The Tax on Early Distributions From Retirement Plans

Extra tax penalties usually apply to early withdrawals from retirement plans.
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Though individual retirement accounts, 401(k) plans, 403(b) plans and other qualified plans are intended to help you save for retirement, you can take money out early in many cases. Early distributions refer to those that you take before you turn 59 1/2 years old. If you do take money out early, you will have to pay the taxes due and may also have to pay a penalty depending on the type of account and the purpose of the withdrawal.

Income Taxes

Early distributions from pretax retirement plans are hit with the same income taxes as if you had taken a qualified distribution, because the entire amount is included in your taxable income. For example, if you take a $5,000 early distribution from a traditional IRA or 401(k) plan, you would have to include that $5,000 in your taxable income. With after-tax plans, such as a Roth 401(k) or Roth 403(b), you divide your early distribution between your contributions, which come out tax-free, and earnings, which are taxable. With a Roth IRA, you remove all of your contributions tax-free first and only then do you have to pay taxes when you withdraw the earnings.

Additional Tax Penalty

When you take an early distribution from a pre-tax retirement plan, you have to pay an additional 10 percent tax penalty on the taxable portion of the distribution. For example, if you take a $9,000 early distribution from your traditional 401(k) plan, not only do you have to pay taxes on the $9,000, but you also owe a $900 additional tax penalty. However, if you took that same distribution from a Roth IRA, and it did not exceed the amount you have contributed, you wouldn't owe taxes or the penalty.

Penalty Exceptions

The Internal Revenue Service recognizes a number of specific circumstances that allow you to avoid the early withdrawal penalty. Certain exceptions, including if you become permanently disabled or you're taking the distribution as a beneficiary because you inherited the account, apply to all types of plans. Others only apply to employer plans or IRAs. For employer plans, you also avoid the penalty if you retire after age 55 and then take distributions or if you take the money out following a qualified domestic relations order. For IRAs, you don't have to pay the penalty if you use the money for higher education expenses or up to $10,000 for a first home. However, even if you qualify for a penalty waiver, you still owe the income taxes.

Tax Reporting

When you take an early distribution, you have to use Form 5329 to figure the penalty on your early withdrawal. If you qualify for the exemption, you still have to complete Form 5329, but you report the amount of the exemption on line 2 and the code for the exemption next to line 2. The codes are found in the instructions for Form 5329.

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