Retirement Savings Withdrawals

Withdrawal of Retirement Account

Retirement Savings

Exceptions to Avoid Early Distribution Penalty

Hopefully, each individual is saving money for his or her retirement. We keep our savings in either the IRA or 401k account until we reach the age of 59 ½ when they can withdraw from the account and use the money for their daily expenses when we retire from work. This is the ideal scenario, but sometimes, there comes a time when we need the money and withdraw from our retirement plan before reaching the minimum age or retirement age. When this happens, early distribution takes place and the government imposes a 10% penalty for the early distribution. The contribution for the said retirement plan directly comes from the taxpayer’s paycheck before withholding the tax or it can be deducted from the paycheck as part of the tax return for IRA contributions.

The 10% penalty for early distribution aims to discourage tax payers from using their retirement money before they retire. The early distribution is also considered as part of an income for the year thus income tax is applicable to it.

As with all taxes, the IRS gives exemptions to those who withdraw from their retirement plan and there are different sets of rules and exemptions for those who are under the IRA and those who are under the 401k.

Generally, taxpayers who withdraw from their retirement plan are exempted if the taxpayer is disabled, if the retirement plan or account was given to you as beneficiary of the deceased plan holder, the distribution was used to pay for an IRS levy, withdrawn by qualified reservists when the taxpayer reaches 55 years old, or the money is used for annuity. These exemptions eliminate the penalty but the distribution is still considered as an added income, therefore you should pay the necessary added income tax for it.

For those who have accounts deposited at the IRA, the 10% penalty is waived if the taxpayer use the money for building or acquiring the taxpayer’s house, paying for college tuition fee and medical expenses of the taxpayer if he is unemployed at the time. If the taxpayer withdrew an amount which exceeds the expenses for the exemption, the amount in excess will have a tax with 10% penalty.

The 401k participants also have exemptions that are exclusively applicable to 401k participants only. The taxpayer can withdraw money and the 10% penalty will be waived if the money is to be used for paying excess contributions. The tax payer can also apply for loans using their 401k account. If the loan was approved by the 401k, the taxpayer could borrow as much as 50% of their account balance and it should be paid within 5 years unless the money is used to buy the taxpayer’s house. The loan is exempted from the penalty as long as it is fully paid within 5 years.

If in case you’ve paid an incorrect penalty for distributions, you can file for a re-computation using the form 5329 and it can be filed not later than 3 years after the due date. When you file for re-computation, you must indicate the tax year that the inappropriate penalty was reflected. The IRS will do the necessary steps to update your record.

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Posted by tax assistant on Monday, December 13th, 2010. Filed under Personal Tax Issues. You can follow any responses to this entry through the RSS 2.0. You can leave a response or trackback to this entry