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Tax laws encourage you to save for retirement. Whether you save through your employer’s plan or on your own with an Individual Retirement Account (IRA), you typically don’t pay income taxes on your contributions until you actually withdraw money from the plan or account after you retire.
Beware that if there’s an early withdrawal or distribution from your tax qualified plan, you’ll likely have to pay a penalty tax. The penalty is on top of any income tax you owe. Fortunately, there are many exceptions where the penalty won’t apply.
Penalty Tax: The General Rule
Typically, if there’s a withdrawal or distribution from your qualified plan or your IRA account before you’re 59 and a half years old , you’ll owe the penalty tax. The amount of the tax is 10 percent of the amount includable in your income. The tax doesn’t apply to parts of the distribution that aren’t taxable.
Exceptions to the Penalty Tax
There might be a pressing reason for your early withdrawal or distribution. There are a number of exceptions to paying the penalty, such as when you take an early withdrawal from a plan or IRA and:
- You’re disabled, as defined by the tax code
- You have unreimbursed medical expenses that are more than 7.5 percent of your adjusted gross income
- You’re the beneficiary of a deceased plan participant or IRA owner
- The distribution is made because the IRS levied or seized the retirement plan
Exceptions for IRAs
Some exceptions to the penalty tax apply only to early withdrawals or distributions from your IRA:
- Health insurance. You may take a penalty-free withdrawal to buy health insurance after you lose your job. To avoid the penalty, you had to have received unemployment compensation for at least 12 weeks; took the distribution during the year unemployment compensation was paid, or in the following year; the amount can’t be more than what you paid during the year for health insurance for yourself, your spouse, and your dependents; and the distribution was made within 60 days after you found a new job
- Educational expenses. You can withdraw up to the amount of qualified education expenses for the year for you, your spouse or dependent
- Home buyer distribution. There’s a $10,000 lifetime limit on this exception
You report the 10 percent penalty on your Form 1040. You may also need to file Form 5329 in some situations. The IRS has detailed instructions for this. Also, you should receive a Form 1099-R when you make the withdrawal. That form has instructions to help you report the penalty or claim one of the exemptions from it.
Questions for Your Attorney
- I was laid off from my job and I’m thinking about withdrawing funds from my IRA. Will the withdrawal fall within an exception to the penalty tax?
- Can I rollover pension plan payments from my old job into the plan offered by new employer? Will I have to pay the penalty?
- I want to take an early distribution from my IRA to pay for my adult child’s graduate school tuition. Is she my “dependent” for purposes of exceptions to the penalty tax?