SIMPLE IRA Early Withdrawal Penalty: Rules and Exceptions

A Savings Incentive Match Plan for Employees, or SIMPLE IRA, offers a straightforward way for small businesses to provide a retirement plan. These accounts allow both employees and employers to make contributions, fostering tax-deferred growth for retirement. Accessing these funds before reaching retirement age can lead to significant tax consequences, as penalties are designed to discourage premature distributions.

The Two-Tier Penalty System

Distributions from most retirement plans before age 59 ½ are generally subject to a 10% additional tax on top of regular income tax. This standard penalty applies to early withdrawals from traditional IRAs and 401(k)s, and it can also apply to SIMPLE IRAs. However, the SIMPLE IRA has a unique, higher 25% penalty for withdrawals taken within a specific 2-year period.

This 2-year window begins on the first day an employer deposits a contribution into the participant’s SIMPLE IRA. The start date is based on this initial deposit, not on when the employee became eligible or the plan was established. This 2-year holding period is distinct for each SIMPLE IRA plan a person participates in.

For example, if an employee’s first contribution was deposited on May 1, 2023, the 2-year period runs until April 30, 2025. Any withdrawal taken before May 1, 2025, would be subject to the 25% additional tax. If that same individual, still under age 59 ½, waits until May 1, 2025, or later to take a distribution, the penalty rate drops to the standard 10%.

Exceptions to the Early Withdrawal Penalty

The Internal Revenue Code provides several exceptions that allow individuals to withdraw funds from a SIMPLE IRA before age 59 ½ without the 10% or 25% penalty. Even when a penalty is waived, the withdrawn amount is still considered taxable income and must be reported on your federal income tax return.

Common exceptions include:

• Death or disability. If the account owner dies, beneficiaries can take penalty-free withdrawals. An account owner who becomes totally and permanently disabled can also take distributions without penalty. To qualify for the disability exception, you must provide proof that you cannot engage in any substantial gainful activity due to a physical or mental condition that is expected to be long-term or result in death.
• First-time home purchase. You can withdraw a lifetime maximum of $10,000 penalty-free to buy, build, or rebuild a first home. This exception can be used by the account owner, their spouse, or their children or grandchildren. A first-time homebuyer is someone who has not owned a principal residence in the two years prior to the new home’s acquisition date, and the funds must be used for qualified costs within 120 days.
• Higher education expenses. Withdrawals can be made to pay for qualified higher education expenses for yourself, your spouse, children, or grandchildren. These expenses include tuition, fees, books, supplies, and equipment required for enrollment at an eligible educational institution. The distribution cannot exceed the total qualified education expenses for the year.
• Unreimbursed medical expenses and health insurance. You can take penalty-free distributions for unreimbursed medical expenses that exceed 7.5% of your adjusted gross income (AGI). Another exception allows individuals who have received unemployment compensation for 12 consecutive weeks to take penalty-free withdrawals to pay for health insurance premiums.

Reporting Withdrawals and Paying the Penalty

When you take a distribution from your SIMPLE IRA, the financial institution will send you Form 1099-R. This form, typically sent by January 31 of the following year, details the amount of the withdrawal and any taxes withheld. Box 7 on Form 1099-R contains a distribution code that tells the IRS the reason for the withdrawal. A standard early distribution is marked with Code 1 (10% penalty), while a withdrawal within the first two years is marked with Code S (25% penalty).

The form for calculating and reporting the additional tax is Form 5329. If you owe a penalty, you will use this form to calculate the exact amount. This form is also where you claim an exemption from the penalty. If you qualify for an exception that is not indicated on your Form 1099-R, you will file Form 5329 and enter the corresponding exception code to waive the penalty.

After completing Form 5329, the calculated penalty amount is transferred to your main tax return, Form 1040. This ensures the additional tax is included in your total tax liability for the year.