Make sure you are meeting the requirements to avoid penalties. A distribution from a retirement plan is considered early when it's participant takes money out of the plan before the age of 59 ½. Since most retirement withdrawals are subject to income tax these early distributions are taxable but may also subject to an additional tax penalty of 10%.
Fortunately, there are several ways that the penalty tax (but not the regular income tax) can be avoided. However, the rules are complex.
Note: The additional penalty tax is 25% if you take a distribution from a SIMPLE IRA in the first two years you participate in the SIMPLE IRA plan.
As the taxpayer in one new court case found, if you don’t meet the requirements, you’ll be forced to pay the penalty.
Basic rules
Some exceptions to the 10% early withdrawal penalty tax are only available to taxpayers who take early distributions from traditional IRAs, while others can only be used with qualified retirement plans such as 401(k)s.
Some examples of exceptions include:
- Paying for medical costs that exceed 7.5% of your adjusted gross income,
- Taking annuity-like annual withdrawals under IRS guidelines,
- Withdrawing money from an IRA, SEP or SIMPLE plan up to the amount of qualified higher education expenses for you, your spouse, children or grandchildren, and
- Taking withdrawals of up to $10,000 from an IRA, SEP or SIMPLE plan for qualified first-time homebuyers.
Facts of the new case
Another exception is available for the total and permanent disability of the retirement plan participant or IRA owner. In one case, a taxpayer took a retirement plan distribution of $19,365 before he reached age 59½, after losing his job as a software developer. According to the U.S. Tax Court, he had been diagnosed with diabetes, which he treated with insulin shots and other medications.
The taxpayer filed a tax return for the year of the distribution but didn’t report it as income because of his medical condition. The retirement plan administrator reported the amount as an early distribution with no known exception on Form 1099-R, which was sent to the IRS and the taxpayer.
The court ruled that the taxpayer didn’t qualify for an exception due to disability. The court noted that an individual is considered disabled if, at the time of a withdrawal, he or she is “unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or to be of long-continued and indefinite duration.”
In this case, the taxpayer was previously diagnosed with diabetes, but he had been able work up until the year at issue. Therefore, the federal income tax deficiency of $4,899 was upheld. (TC Memo 2023–9)
Lessons learned
As the taxpayer in this case discovered, taking early distributions is one area where guidance is important. Your Rudler, PSC advisor can help you determine if you’re eligible for any exception to the 10% early withdrawal penalty tax. Contact us at 859-331-1717.
RUDLER, PSC CPAs and Business Advisors
This week's Rudler Review is presented by Erin Mauch, Staff Accountant and Karen Daugherty, CPA.
If you would like to discuss your particular situation, contact Erin or Karen at 859-331-1717.
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