Early Retirement Withdrawal Trap: Don’t Get Burned – Know the Rules, Avoid Penalties!
Saving for retirement is a long-term goal that requires discipline and patience. However, sometimes life throws you a curveball and you need to access your retirement savings before you reach the age of 59 ½. Whether it is for an emergency, a major purchase, or a change of plans, taking early withdrawals from your retirement accounts can have serious tax implications that you need to be aware of.
In this article, we will explain the rules and exceptions for taking early withdrawals from different types of retirement accounts, such as IRAs, 401(k)s, and 403(b)s. We will also show you how to report your early withdrawals to the IRS and how to avoid or reduce the penalties and interest that may apply to your withdrawals. Finally, we will provide some tips and resources to help you plan your retirement savings and avoid unnecessary taxes and penalties.
What are the Rules for Taking Early Withdrawals from Retirement Accounts?
The rules for taking early withdrawals from retirement accounts depend on the type of account you have and the reason for your withdrawal. Generally, there are two types of retirement accounts: IRAs and IRA-based plans, and workplace retirement plans such as 401(k), 403(b), and 457(b) plans.
IRAs and IRA-based plans
IRAs and IRA-based plans are individual retirement accounts that you set up and contribute to on your own or through your employer. They include traditional IRAs, Roth IRAs, SEP-IRAs, and SIMPLE-IRAs. You can take distributions from these accounts at any time, without having to show a hardship or a specific reason. However, you will have to pay income tax on the taxable portion of your distribution, unless it is a qualified distribution from a Roth IRA. A qualified distribution from a Roth IRA is one that is made after you have had the account for at least five years and you are at least 59 ½ years old, or you meet another exception such as death or disability.
In addition to income tax, you may also have to pay an additional 10% tax on the taxable portion of your distribution if you take it before you reach the age of 59 ½, unless you meet an exception. The additional 10% tax is also known as the early distribution tax or the penalty tax. There are more than 20 exceptions to this tax, including some that are specific to IRAs and IRA-based plans. For example, you can take up to $10,000 from your IRA to buy or build your first home, or you can use your IRA funds to pay for qualified higher education expenses for yourself, your spouse, or your dependents.
Workplace retirement plans
Workplace retirement plans are employer-sponsored plans that allow you to save for retirement by deferring part of your salary or receiving employer contributions. They include 401(k), 403(b), and 457(b) plans. You can take distributions from these plans only when certain life events occur, such as retiring, becoming disabled, or leaving your job. The plan’s summary description should clearly state when you can take a distribution from the plan while still working for that employer. Many plans also allow you to take a distribution on account of a hardship, or take a loan from the plan for any reason.
Distributions from workplace retirement plans are subject to income tax, unless they are designated Roth contributions or qualified distributions from a designated Roth account. A designated Roth account is a separate account within your plan that allows you to make after-tax contributions and receive tax-free distributions if certain requirements are met. A qualified distribution from a designated Roth account is one that is made after you have had the account for at least five years and you are at least 59 ½ years old, or you meet another exception such as death or disability.
Similar to IRAs and IRA-based plans, you may also have to pay an additional 10% tax on the taxable portion of your distribution if you take it before you reach the age of 59 ½, unless you meet an exception. The exceptions to this tax are mostly the same as those for IRAs and IRA-based plans, but there are some differences. For example, you can take a distribution from your workplace retirement plan after you separate from service after reaching age 55, or you can take a distribution under a qualified domestic relations order (QDRO) that assigns part of your plan benefits to your former spouse or dependent.
How to Report Early Withdrawals from Retirement Accounts to the IRS?
If you take an early withdrawal from your retirement account, you need to report it as gross income on your tax return, unless it is a qualified distribution from a Roth IRA or a designated Roth account. You also need to report any early distribution tax that applies to your withdrawal, unless you meet an exception. To report your early withdrawal and the tax to the IRS, you need to follow these steps:
- Include the amount of your distribution on your Form 1040, Individual Income Tax Return, on the line for IRA distributions or pensions and annuities, depending on the type of your account. You will receive a Form 1099-R, Distributions from Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., from your plan administrator or financial institution that shows the amount and the taxable portion of your distribution. You can use this form to fill out your Form 1040.
- Report any early distribution tax on your Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts. You need to file this form if you owe the 10% tax on your distribution, or if you meet an exception and want to claim it. You need to enter the amount of your distribution, the amount of the tax, and the exception code that applies to your situation. You can find the list of exception codes and their descriptions in the instructions for Form 5329.
- Report any qualified disaster distributions and repayments on Form 8915-F, Qualified 2020 Disaster Retirement Plan Distributions and Repayments. You need to file this form if you took a distribution from your retirement account because of a federally declared disaster that occurred in 2020, and you want to spread the income tax over three years or repay the distribution within three years. You need to enter the amount of your distribution, the amount of the tax, and the amount of the repayment, if any. You can find more information about qualified disaster distributions and repayments in the instructions for Form 8915-F.
How to Avoid Penalties and Interest on Early Withdrawals from Retirement Accounts?
The best way to avoid penalties and interest on early withdrawals from retirement accounts is to avoid taking early withdrawals in the first place. However, if you have already taken an early withdrawal, or you have no choice but to take one, you may be able to reduce or eliminate the penalties and interest by following these tips:
- Check if you qualify for an exception to the 10% early distribution tax. There are more than 20 exceptions that may apply to your situation, depending on the type of your account, the reason for your withdrawal, and the amount of your withdrawal. Some of the common exceptions are death, disability, first-time homebuyer, qualified higher education expenses, qualified military reservist, separation from service after age 55, and QDRO. If you meet an exception, you need to report it on your Form 5329 and enter the appropriate exception code.
- Consider rolling over your distribution to another retirement account. If you take a distribution from your retirement account, you may be able to roll it over to another retirement account of the same type within 60 days, and avoid paying any tax or penalty on the distribution. However, you can only do one rollover per year, and you cannot roll over a distribution from a Roth IRA or a designated Roth account. You also cannot roll over a distribution that is part of a series of substantially equal periodic payments, a required minimum distribution, a hardship distribution, or a qualified disaster distribution. If you do a rollover, you need to report it on your Form 1040 and enter the amount of the rollover on the line for rollovers.
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***Disclaimer: This communication is not intended as tax advice, and no tax accountant -client relationship results**