How does the 10% penalty on IRA and 401k distributions work?

Many people, especially after leaving a job, make the decision to cash out their 401k accounts. Sometimes people end up in a financial hardship where they need to liquidate retirement savings early. These distributions are almost always taxable (qualified Roth and after-tax money is not); but for most people under age of fifty-nine and a half, there is an additional 10% penalty.

Taking a taxable distribution from a 401k, IRA, or pension

When you take a taxable distribution from a 401k, pension, or IRA account, that is ordinary income and computed as part of your taxable income for the year. Not only do you pay tax on the distribution but it can push your income into a higher tax bracket. A non-taxable distribution from retirement accounts include rollovers to another qualified account or a distribution of qualified Roth money.

10% penalty on taxable distributions from 401k or pension

In addition to income tax, Congress instituted Internal Revenue Code section 72(t) which is the 10% penalty. It is a deterrent to keep people from taking early distributions from their retirement savings. In addition to the income tax, you will pay an extra 10% as a penalty. So for example, if you take a $10,000 distribution from your 401k after you leave the company and your tax rate is 25% for the year, you would owe $2,500 in income tax plus an additional $1,000 for the 10% penalty. You would owe $3,500 to the IRS and leave you just $6,500.

10% penalty exceptions

Congress carved out several exceptions to the penalty where it determined the use of retirement funds – in its opinion –deserves to avoid the penalty. The biggest exclusion from the penalty is taking distributions after 59.5 years old. Any distributions from your retirement accounts after this age do not incur the penalty. In addition to the age 59.5 cutoff, there are exceptions that allow people under the age of 59.5 to take early distributions without incurring the penalty:

  • If you leave your job after on or after age 55 you can take distributions at any time from an employer-sponsored retirement plan (not an IRA) without penalty. If you rollover that plan to an IRA the exception goes away. Consider this before a rollover to an IRA until after you turn 59.5.
  • You have unreimbursed medical expenses that exceed 7.5% of your adjusted gross income.
  • If the distribution is from an IRA and the distribution is less than or equal to the cost of medical insurance.
  • You have been deemed disabled (by Social Security Administration).
  • You are the beneficiary of a deceased plan participant or IRA holder.
  • If the distribution is from an IRA and not more than qualified higher education expenses for the year.
  • An IRA distribution of $10,000 or less to purchase the account holder’s first primary residence.
  • The distribution is due to an IRS levy.
  • The distribution is a qualified reservist distribution.
  • A timely distribution to reduce excess elective deferrals or excess contributions from either the employee or employer.
  • To an alternate payee under a qualified domestic relations order (QDRO).
  • The distribution is dividends from an ESOP.
  • The distribution is a permissive withdrawal of an elective automatic contribution arrangement (EACA). If your employer’s 401k plan automatically enrolls you and withholds contributions from your paycheck although you did not want to participate in the plan, in certain circumstances some plans may allow you to take these automatic contributions back from the plan.
  • The payments are substantially equal periodic payments. This is a tricky exception that easily risks causing problems if the distributions are not set up appropriately. The entire account pays as substantially equal periodic payments so the entire account distributes to you by the last expected payment. These payments can be annuitized for the account owner’s remaining life expectancy and avoid the penalty, even if payments start before age 59.5. This requires implementing an appropriate annuitization calculation so that the payments should exhaust the account by the end of the account holder’s life. However, the payments can be for less than the entire life. Periodic payments must extend for the later of five years or age 59.5. These payments  should exhaust the account with the last periodic payment. (Although based on investment profits or losses, it may not actually coincide.) If you take payment at age 30, they must extend until age 59.5 because it takes longer to reach 59.5 than five years; but if you start the periodic payments at age 57 the payments must extend until 62. The five year period is longer than reaching age 59.5.

If you are contemplating an early distribution and believe an exception applies, you should speak with a qualified tax professional. The above information is not tax advice. It is purely informational and does not contemplate your situation.

Dallas and Fort Worth employment attorney for 401k and pension issues

If you are experiencing a problem with your 401k, pension, or other employer-sponsored retirement plan in Dallas or Fort Worth then contact my office to learn more about how I can help you as an employment attorney. 401k and pension problems arise due to mismanagement by the plan administration. This may come in the form of inappropriate fees, mismanaging assets, wrongfully denying benefits and other acts. If you believe your employer may have mismanaged or wrongfully denied benefits under a 401k or pension then you should talk to an employment lawyer. Employment lawyers help clients with benefit claims against their employers.

Visit the employee benefits page to learn more about your benefits and how an employment lawyer can help protect your rights.

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