What Is the 10 Percent Condition in Finance?

What is the 10 Percent Condition

The “10 percent condition” refers to an additional tax imposed on certain withdrawals from retirement accounts. This measure is designed to encourage individuals to save for their long-term financial security by discouraging early access to retirement funds.

Application of the 10 Percent Additional Tax

The 10% additional tax generally applies to distributions from qualified retirement plans and individual retirement arrangements (IRAs) made before the account holder reaches age 59½. This includes common plans such as 401(k)s, 403(b)s, and traditional IRAs. The purpose of this rule is to disincentivize individuals from using these accounts as short-term savings vehicles and instead promote their use for retirement.

This additional tax is calculated as 10% of the taxable portion of the distribution. For instance, if a distribution from a traditional IRA includes both pre-tax contributions and earnings, the 10% tax applies to the entire amount unless after-tax contributions (basis) are being returned. It is important to note that this 10% is an additional tax, meaning it is levied on top of the ordinary income tax that is typically due on such distributions.

Exceptions to the 10 Percent Additional Tax

While the 10% additional tax broadly applies to early distributions, several exceptions exist that allow individuals to access their retirement funds without incurring this penalty. These exceptions are specific and aim to address various life events or financial hardships. It is important to remember that even if an exception applies, the distribution may still be subject to regular income tax.

Exceptions include:
Death or Total and Permanent Disability: Distributions made due to the death or total and permanent disability of the account holder. In the case of death, beneficiaries inheriting a retirement account can take distributions penalty-free, regardless of their age. For disability, the individual must be unable to engage in any substantial gainful activity due to a physical or mental condition.
Medical Expenses: If unreimbursed medical expenses exceed 7.5% of the taxpayer’s adjusted gross income (AGI), the amount of the distribution up to the excess can be taken without the 10% penalty. This exception applies to both IRAs and employer-sponsored plans.
Health Insurance Premiums (Unemployed): Distributions used for health insurance premiums while unemployed, though this typically applies only to IRAs.
Qualified Higher Education Expenses: Distributions for the account holder or their dependents are generally exempt from the penalty, but this exception also primarily applies to IRAs.
First-Time Homebuyers: Up to $10,000 as a lifetime limit from an IRA without the 10% penalty, provided the funds are used for qualified acquisition costs of a home for themselves or certain family members. To qualify, the individual generally cannot have owned a main home in the two-year period prior to the purchase.
Substantially Equal Periodic Payments (SEPPs): Also known as Rule 72(t) payments, these allow individuals to take a series of equal payments over their life expectancy without penalty. Once established, these payments must continue for a minimum of five years or until age 59½, whichever is later, to avoid recapture of the penalty.
Qualified Reservist Distributions: Exempt for military reservists called to active duty for a period exceeding 179 days. Distributions made after separation from service at age 55 or older (or age 50 for certain public safety employees in governmental plans) are exempt from the penalty, but this exception applies specifically to qualified employer plans, not IRAs.
Recent Legislative Changes: These include distributions for qualified birth or adoption expenses, up to $5,000 per child. Another new exception permits withdrawals for emergency personal expenses, generally up to $1,000 per year, and distributions for victims of domestic abuse, with specific limitations, both effective after December 31, 2023.

Reporting the 10 Percent Additional Tax

When an early distribution is taken from a retirement account, the additional 10% tax, or an applicable exception, is typically reported to the Internal Revenue Service (IRS). The primary form used for this purpose is IRS Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts.

Form 5329 is used to calculate the amount of the additional tax owed or to claim an exception that exempts the distribution from the penalty. Information from Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., is commonly used to complete Form 5329. This includes details about the distribution amount and the distribution code.

While Form 5329 is generally required for reporting early distributions subject to the 10% additional tax, there are instances where it might not be necessary. For example, if Form 1099-R correctly indicates that the entire distribution is subject to the penalty, the tax may be reported directly on Schedule 2 (Form 1040) without filing Form 5329. However, if an exception applies but is not correctly coded on Form 1099-R, filing Form 5329 is necessary to claim the exception.