How Much Is Retirement Taxed for Early Withdrawal?

Taking money from a retirement account before reaching a certain age is known as an early withdrawal. The Internal Revenue Service (IRS) defines this as a distribution taken before you turn 59½. These withdrawals often have significant tax consequences that can reduce the amount of money you ultimately receive. An early withdrawal is subject to two main financial hits: ordinary income tax and an additional tax penalty. The entire amount you take out is added to your income for the year, and a penalty is assessed to discourage premature use of funds set aside for retirement.

The 10% Additional Tax on Early Distributions

A primary consequence of taking an early distribution from a retirement plan is the 10% additional tax imposed by the IRS. This is a flat-rate penalty applied to the taxable portion of the withdrawal. It is not a tax on the entire account balance, but only on the amount you take out before age 59½. This penalty is levied in addition to any regular federal and state income taxes you will owe on the distribution.

This additional tax applies to a wide range of tax-advantaged retirement accounts. These include traditional Individual Retirement Arrangements (IRAs), SEP IRAs, and SIMPLE IRAs. It also covers employer-sponsored plans such as 401(k)s, 403(b)s, and most governmental 457(b) plan distributions that are attributable to rollovers from other plan types.

It is important to distinguish this 10% penalty from the ordinary income tax that also applies. The two are calculated separately and added together to determine the total tax impact of the withdrawal. For instance, if you withdraw $10,000, the additional tax would be $1,000, but you would still need to calculate and pay the regular income tax on that same $10,000. An exception exists for SIMPLE IRAs, where the penalty can be as high as 25% if the withdrawal occurs within the first two years of participation.

Ordinary Income Tax Treatment of Withdrawals

Beyond the 10% penalty, any amount you withdraw early from a traditional retirement account is treated as ordinary income for the year. This means the distribution amount is added to your other earnings, such as wages, salaries, and self-employment income, to determine your total gross income. This inclusion can have a significant effect on your overall tax liability, as it may push you into a higher marginal tax bracket.

Consider a scenario where an individual with $75,000 in taxable income decides to take a $10,000 early distribution from their 401(k). That $10,000 is added to their income, raising their total taxable income to $85,000 for the year. The withdrawal will be taxed at their highest marginal tax rate, which could be 22% or higher depending on their filing status and the tax brackets for that year.

For distributions from employer-sponsored plans like a 401(k), the plan administrator is required to withhold 20% of the distribution for federal income taxes automatically. This is a prepayment of the taxes you will owe. If your actual tax liability on the withdrawal is more or less than 20%, the difference will be settled when you file your annual tax return. This mandatory withholding does not apply to IRA distributions, though you can opt for voluntary withholding.

Common Exceptions to the Additional Tax

While the 10% additional tax is a general rule, the IRS provides several specific exceptions that allow for penalty-free early withdrawals, although ordinary income tax still applies. One of the most significant exceptions is for distributions made due to a total and permanent disability. To qualify, you must be able to furnish proof that you cannot engage in any substantial gainful activity because of a physical or mental condition. Another common exception relates to unreimbursed medical expenses, where you can take a penalty-free distribution to the extent that your medical expenses exceed 7.5% of your adjusted gross income (AGI). Distributions made to a beneficiary after the death of the retirement account owner are also exempt from the 10% penalty.

Other situations that may qualify for a penalty waiver include:

• Withdrawing up to $5,000 penalty-free within one year of the birth or legal adoption of a child.
• Using up to $10,000 from an IRA for qualified first-time homebuyer acquisition costs, which has a lifetime cap.
• Paying for qualified higher education expenses for yourself, your spouse, your children, or your grandchildren.
• Taking distributions from an employer’s plan after separating from service during or after the year you turn 55 (or age 50 for qualified public safety employees).
• Receiving a series of substantially equal periodic payments over your life expectancy.
• Withdrawing the lesser of $10,000 or 50% of your account balance for victims of domestic abuse.
• Taking up to $22,000 for losses due to a federally declared disaster.
• Withdrawing up to $1,000 per year for unforeseeable personal or family emergency expenses.

State Tax Implications

In addition to federal taxes, early withdrawals from retirement accounts can also be subject to state income taxes. The rules governing the taxation of these distributions vary significantly from one state to another. Some states fully conform to the federal rules, meaning they also impose a penalty on early withdrawals and recognize the same set of exceptions.

Other states have their own distinct regulations. A state might impose its own penalty, which could be a different percentage than the federal 10% rate. Conversely, some states do not tax retirement income at all, which would mean neither the distribution nor any associated penalty would be subject to state tax.

Reporting Early Withdrawals on Your Tax Return

After taking an early distribution, the financial institution will send you Form 1099-R. This form provides key details about the distribution, including the gross amount, the taxable amount, and a distribution code in Box 7. This code tells the IRS the reason for the distribution; for example, a Code 1 indicates an early distribution with no known exception, while a Code 2 suggests an exception applies.

You must file Form 5329, Additional Taxes on Qualified Plans, to calculate the 10% additional tax or to claim an exemption. If you owe the penalty, you will calculate it on Part I of Form 5329 and report the amount on your Form 1040.

If you qualify for an exception, you still need to file Form 5329 to claim it. On the form, you will enter the amount of the distribution that is exempt from the penalty and the corresponding exception code number to ensure you are not improperly assessed the tax.