If your qualified retirement plan has a provision for early withdrawal, any distributions taken from the plan prior to the plan participant reaching age 59 ½ will incur a 10 percent penalty. This penalty is in addition to any income tax owed on the distribution. The purpose for the rule is to discourage the withdrawal of retirement funds for uses other than retirement. See our example below.

As with most rules, there are some exceptions. For example, if the distribution comes from a SIMPLE IRA and no exceptions apply, the penalty increases to 25 percent for the first two years of participation in the SIMPLE IRA plan.

Other exceptions include:

  1. Distributions made because of death or disability
  2. Distributions used to pay medical expenses
  3. Payments structured as a series of substantially equal payments
  4. Qualified plan distributions made pursuant to a qualified domestic relations order (QDRO )
  5. IRA distributions used for first-time home purchases (up to $10,000)
  6. IRA distributions used to pay for higher education expenses

Let’s look at a simple example. Judy Jarrett, age 57, withdraws $8,000 from her qualified retirement to pay for a three-week cruise in the Caribbean. Judy’s withdrawal doesn’t meet any of the exceptions below. The $8,000 is considered an early distribution, so Judy pays a 10 percent penalty of $800 on the withdrawal. In addition, she must pay 18 percent federal income tax (her current tax rate) on the $8,000. The penalty alone is enough to make Judy think twice about using her retirement nest egg to fund her vacation.

For more information on taxes related to early distributions from retirement plans, visit IRS tax topic 558 online. To learn how this could impact your individual financial or retirement situation, please call us at 206-386-5455. We can put it all in perspective.

To your wealth,

Joe Maas, CFA, AVA, CFP®, ChFC, CLU®, MSFS, CCIM
President of Synergetic Finance