Exceptions to Early Distribution Penalties
Most people who have retirement accounts--either IRAs or qualified plans through an employer--understand the importance of leaving these funds untouched until retirement age. If fear of being a penniless retiree isn't enough, the government enforces a number of rules and penalties to discourage early withdrawals.
If you take a distribution from your retirement plan early--defined as before the day you turn 59 1/2--you will generally be subject to a 10% early distribution tax above and beyond any regular income taxes you may owe on that income. That extra 10% may be called a tax, but it looks and feels like a penalty. In fact, the early distribution tax is the cornerstone of the government's campaign to encourage us to save for retirement--or put another way, to discourage us from plundering our savings before our golden years.
Of course, it's generally a bad idea to dip into your retirement plan early except in extraordinary circumstances. But when using your retirement funds is your only option, it's good to know that there are several ways to avoid the extra 10% tax on early distributions.
Substantially Equal Periodic Payments
The substantially equal periodic payment exception is available to anyone with an IRA or a retirement plan, regardless of age, which makes it an attractive escape hatch.
Theoretically, if you begin taking distributions from your retirement plan in equal annual installments, and those payments are designed to be spread out over your entire life or the joint life of you and your retirement plan beneficiary, then the payments will not be subject to an early distribution tax.
If you think you might need to tap your retirement plan early, this is the option that is most likely to work for you. One caveat: If you want to begin withdrawing funds from your employer's plan, you must have terminated your employment before payments begin. If the payments are from an IRA, however, the status of your employment is irrelevant.
Leaving Your Job After Age 55
If you are at least 55 years old when you leave your job, any distribution you receive from your former employer's retirement plan will not be subject to an early distribution tax. This exception applies only to distributions you receive after you have separated from service, or terminated your employment with the company that sponsors the plan. You don't have to retire permanently. You can go to work for another employer, or even return to work for the same employer at a later date. But you cannot receive a distribution from your employer's retirement plan while you are still employed with the company, if you want to use the age 55 exception to the early distribution tax.
This exception is relevant only if you are between ages 55 and 59 1/2. After age 59 1/2, the early distribution tax does not apply to any retirement plan distribution.
As with other exceptions, the devil is in the details. For this exception, you need not be age 55 on the day you leave your job, as long as you turn 55 by December 31 of the same year. The strategy falls apart if you retire in a year that precedes the year you turn 55, even if you postpone receiving the retirement benefits until you reach age 55.
Dividends from ESOPs
An employee stock ownership plan, or ESOP, is a type of stock bonus plan which may have some features of a more traditional pension plan. ESOPs are designed to be funded primarily or even exclusively with employer stock. An ESOP can allow cash distributions, however, as long as the employee has the right to demand that benefits be paid in employer stock.
Distributions of dividends from employer stock held inside an ESOP are not subject to the early distribution tax, no matter when you receive the dividend.
If you withdraw money from a retirement plan to pay medical expenses, a portion of that distribution might escape the early distribution tax. But once again, the exception is not as simple or as generous as it sounds. The tax exemption applies only to the portion of your medical expenses that would be deductible if you itemized deductions on your tax return. Medical expenses are deductible if they are yours, your spouse's or your dependent's. But they are deductible only to the extent they exceed 7.5% of your adjusted gross income. Consequently, your retirement plan distribution will avoid the early distribution tax only to the extent it also exceeds the 7.5% threshold.
On the plus side, the medical expense exception is available even if you don't itemize deductions. It applies to those amounts that would be deductible if you did itemize.
If you are paying child support or alimony from your retirement plan, or if you intend to distribute some or all of the plan to your former spouse as part of a property settlement, none of those payments are subject to the early distribution tax as long as there is a Qualified Domestic Relations Order (QDRO) in place that orders the payments. A QDRO usually arises from a separation or divorce agreement, and involves court-ordered payments to an " alternate payee," such as an ex-spouse or minor child.
Another way to escape the early distribution tax, albeit a rather unattractive one, is to die before the distribution is made. None of the funds distributed from your retirement plan after your death--for instance, to a named beneficiary--will be subject to the early distribution tax, as long as the account is still in your name when the distribution occurs.If you are the beneficiary of your spouse's retirement plan or IRA, then upon your spouse's death you may roll over a distribution from your spouse's retirement plan or IRA to an IRA in your own name and avoid paying the tax. This benefit is available only to a spouse.
If you become disabled, all subsequent distributions from your retirement plan are free of the early distribution tax. But what does it mean to be disabled? And who decides? The law defines disabled as the inability 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." Hmmm.
The key to the disability exception seems to lie in the permanence of the condition, not the severity. Disability exceptions have been denied for chemical dependence and chronic depression, even when the taxpayers were hospitalized for those conditions. It also appears that the disability must be deemed permanent at the time of the distribution--regardless of whether it is later found to be permanent. For example, the IRS denied the exception for one taxpayer whose disability was not deemed permanent at the time the distribution was paid--even though the taxpayer later qualified for Social Security disability benefits because the disability was ultimately determined to be permanent.
If you receive a refund of a contribution to your retirement plan because you contributed more than you were permitted to deduct during the year, those " corrective" distributions will not be subject to the early distribution tax, although they might be subject to other taxes and penalties. In order to avoid the early distribution tax, the excess must come out of the plan within a prescribed time--usually before you file your tax return. Corrective distributions are usually handled by the plan administrator.
Copyright 1999 Nolo.com, Inc.