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PERSONAL FINANCE

Exceptions to Early Distribution Penalties

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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.

Medical Expenses

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.

QDRO Payments

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.

Death

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.

Disability

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.

Refunds

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.

Special Rules for IRAs

The early distribution tax rules apply to traditional IRAs (non-Roth IRAs) in much the same way they apply to qualified plans, with just a few exceptions and variations.

No Age 55 Exception. With qualified plans, employees who are at least age 55 when they terminate their employment will not be subject to an early distribution tax on distributions from their former employer's qualified plan. This rule does not apply to IRAs, however. If you have an IRA, the only age-related way to escape the early distribution tax is to reach the age of 59 1/2 before taking a distribution--in other words, not to take the distribution " early."

No QDRO Exception. The special QDRO rules in the Tax Code do not apply to IRAs. Even if your divorce agreement or court order mandates child support or alimony payments from an IRA, the payments will be subject to an early distribution tax (unless one of the other exceptions applies).

Health Insurance Premiums. If you are unemployed or were recently unemployed and use money from your IRA to pay health insurance premiums, the IRA funds used specifically for that purpose will not be subject to an early distribution tax, as long as you satisfy the following conditions:

  • you received unemployment compensation for at least 12 consecutive weeks
  • you received the funds from the IRA during a year in which you received unemployment compensation or during the following year, and
  • the IRA distribution is received no more than 60 days after you return to work.

You may also make a penalty-free withdrawal from your IRA to pay for health insurance if you were self-employed before you stopped working, as long as you would have qualified for unemployment compensation had you not been self-employed.

Refunds. There is a limit to how much you may contribute to an IRA each year. If you contribute too much, then you have made an " excess contribution." If you withdraw the excess by the time you file your tax return, the excess will not be subject to the early distribution tax. You must also withdraw the income earned on the excess while it was in the IRA, however, and that portion will be subject to the early distribution tax, unless it qualifies for another exception.

Copyright 1999 Nolo.com, Inc.




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