As an incentive to keep retirement plan assets from being siphoned off prior to an individual’s actual retirement, the federal tax code imposes an additional 10% penalty on the taxable amount of funds withdrawn from either an employer sponsored qualified retirement plan or an IRA prior to reaching age 59 ½. However, there are several exceptions to the penalty in the event there is a need or desire to access retirement funds prior to age 59 ½. Those exceptions can be found in Section 72(t) of the Internal Revenue Code. Knowledge of these rules and some careful planning may result in some significant tax savings for individuals.
At the outset it is important to note that the exceptions can differ depending upon whether the withdrawal is coming from an employer sponsored retirement plan vs. an IRA. Second, remember that the penalty is calculated on the “taxable” amount withdrawn only, so any portion of the distribution that represents non-taxable after-tax dollars is not subject to the penalty.
Notable exceptions to the penalty include:
- Distributions to a beneficiary as a result of the death of the plan participant or IRA owner.
- Distributions on account of the participant’s/ IRA owner’s disability
- Part of a series of substantially equal annual or more frequent payments made over the life of the participant / IRA owner (or joint life expectancy of such individual’s designated beneficiary
- Distributions made to a qualified plan participant on account of his or her separation from service from his employer after reaching age 55
- Payments for otherwise deductible medical expenses
- Payments to “alternate payees” pursuant to a Qualified Domestic Relations Order (QDRO)
- Distributions (from IRAs only) for first time home purchases (up to $10,000)
- Distributions (from IRAs only) for higher education expenses of the IRA owner or such owner’s spouse, children or grandchildren
I have encountered unfortunately several situations where better knowledge of these rules could have save an individual from some significant penalties. Examples include:
1. A 53-year old ex-spouse who withdrew her account balance representing QDRO benefits in a company retirement plan and rolled them into her own IRA before withdrawing them. (The exception didn’t apply to the IRA withdrawal but would have applied had the distribution been taken directly from the company retirement plan.)
2. A 50-year old employee takes his entire retirement plan benefit in a taxable lump sum distribution because he has an immediate need to access 50% of the funds. (The employee should have limited his withdrawal to the amount he needed and kept the balance in his employer plan or rolled the unused amount in an IRA to avoid the penalty on that amount.)
3. An employee terminates employment at age 56 and transfers his entire company retirement plan benefit to his Rollover IRA before withdrawing funds from the IRA prior to age 59 ½. (Again, the exception would have applied had the needed funds been withdrawn from the company retirement plan rather than the IRA.)
As you can see, there are nuances to each of these exceptions so the best way to avoid many of these pitfalls is to seek the counsel of a tax professional before making such withdrawals.