Tax Tip of the Week: Understanding Retirement Distributions

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Did you tap into your 401(k) or IRA in 2008? Naughty, naughty taxpayer. If you took an early distribution from your retirement plan, you should know you’ll probably be punished.

Early Distributions From Retirement Accounts Are Hit With 10% Penalty

Payments out of retirement accounts prior to age 59 ½ are generally considered early or premature distributions, and as such are reported to the IRS so they can impose an additional 10% penalty tax.

(If you rolled the distribution into another qualified plan within 60 days, no worries. You’ll still have to report it, but it doesn’t count as a withdrawal.)

The 10% additional tax is above and beyond the whatever marginal income tax bracket you fall into. That’s what makes it so painful. It’s an easy detail to overlook when you’re strapped for cash. Fortunately, there are a few exceptions that might still save you.

Exceptions to the 10% Penalty Tax Rule

The IRS has shown a few small kindnesses when it comes to retirement distributions. However, most of them don’t have anything to do with the fact that you lost your job and need to put food on the table. Still, you may find you fall into one of the exceptions. Distributions are not subject to the 10% penalty taxed when used for the following:

  • Purchase, build, or rebuild a first home.
  • Medical expenses that exceed 7.5% of your Adjusted Gross Income (AGI).
  • Medical insurance – IF you lost your job and received unemployment benefits for 12 weeks. (Distribution amount can’t exceed cost of insurance and a couple of timing conditions apply.)
  • Qualified higher education expenses for yourself, a child, or grandchild.
  • To pay for damage due to severe storm damage in certain disaster area states (See IRS Publication 590 for complete details.)
  • If you become disabled.
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You’ll still be subject to income tax, but knowing the rules may help you to avoid the 10% additional tax.

Image Credit: kevindooley, Flickr