What Is the Additional Tax on Early Distributions?

Taking money from a retirement account ahead of schedule can have tax implications beyond ordinary income tax. Federal law encourages long-term saving by imposing a penalty on certain withdrawals deemed “early.” This penalty is an additional tax on top of any regular income tax you might owe on the distribution. The purpose is to discourage using retirement funds for non-retirement purposes, preserving them for their intended use.

The 10% Additional Tax Rule

The Internal Revenue Service (IRS) defines an “early” distribution as a withdrawal from a qualified retirement plan before you reach age 59½. If you take such a distribution, you will owe your regular income tax on the withdrawn amount, plus an additional 10% tax. This penalty applies to the portion of the distribution that is includible in your gross income, not the entire withdrawal if part of it represents non-deductible contributions.

The rule applies to employer-sponsored plans like 401(k)s and 403(b)s, and individual retirement arrangements (IRAs) like Traditional, SEP, and SIMPLE IRAs. The tax on governmental 457 plan distributions often only applies to funds rolled over from another qualified plan. For SIMPLE IRAs, a 25% additional tax can apply if you take a distribution within the first two years of participation.

Roth IRA Distributions

Roth IRAs have a unique structure affecting how the early distribution tax is applied. Because contributions to a Roth IRA are made with after-tax money, you can withdraw your direct contributions at any time and at any age, tax-free and penalty-free. The 10% additional tax only applies when you start withdrawing the earnings from your Roth IRA.

For earnings to be withdrawn tax-free and penalty-free, the distribution must be “qualified.” A qualified distribution requires that you have held a Roth IRA for at least five years and are over age 59½, are disabled, or are using the funds for a first-time home purchase. If you withdraw earnings before meeting these criteria, those earnings will be subject to both ordinary income tax and the 10% additional tax, unless an exception applies.

Common Exceptions to the Early Distribution Tax

The tax code provides numerous exceptions that allow for penalty-free access to retirement funds in specific situations. Each exception has distinct requirements that must be met to avoid the penalty. Regular income tax may still apply to the taxable portion of the distribution.

Death or Disability

An exception is for distributions made to a beneficiary after the death of the account owner. The person inheriting the account can take distributions without the 10% additional tax, regardless of their age. Another exception applies if you become totally and permanently disabled, meaning you can furnish proof that you cannot engage in any substantial gainful activity due to a long-lasting physical or mental condition. An exception is also available for individuals who are terminally ill.

Hardships and Emergencies

Individuals may take a penalty-free distribution of up to $1,000 per year for unforeseeable personal or family emergency expenses. In cases of domestic abuse, a victim may withdraw the lesser of $10,000 or 50% of their vested account balance within one year of the incident. Those affected by federally declared disasters can withdraw up to $22,000 without penalty.

Medical and Family Needs

Several exceptions relate to medical and family needs, including:

• Covering unreimbursed medical expenses that exceed 7.5% of your adjusted gross income (AGI).
• Paying for health insurance premiums after receiving unemployment compensation for 12 consecutive weeks.
• Paying for qualified higher education expenses for yourself, your spouse, children, or grandchildren.
• Withdrawing up to a $10,000 lifetime limit from an IRA for a first-time home purchase.
• Withdrawing up to $5,000 for expenses related to a qualified birth or adoption.

Payments and Other Circumstances

Other circumstances that allow for penalty-free withdrawals include:

• Taking distributions as part of a series of substantially equal periodic payments (SEPP) over your life expectancy; modifying the payment schedule can trigger retroactive penalties.
• Making distributions to satisfy an IRS levy on your qualified retirement plan.
• Taking withdrawals as a qualified military reservist called to active duty for more than 179 days.
• Making a distribution to an alternate payee, such as an ex-spouse, under a Qualified Domestic Relations Order (QDRO).

How to Report Early Distributions on Your Tax Return

You must report an early distribution to the IRS, whether you owe the additional tax or qualify for an exception. This is done using Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts. This form is used to calculate the 10% penalty or to claim an exception.

You will receive a Form 1099-R from your financial institution detailing your distribution, which is needed to complete Form 5329. If you owe the tax, you will use Part I of the form to calculate it. Report the taxable portion of the distribution on line 1 and compute the 10% tax on line 4.

If you qualify for an exception, you must still file Form 5329 to claim it. On line 2, you will enter the amount of the distribution subject to an exception and the corresponding two-digit exception code from the form’s instructions. For example, the code for a disability distribution is 03, and the code for medical expense distributions is 05.

After completing Form 5329, the total additional tax is transferred to Schedule 2 of Form 1040 and included in your total tax liability for the year.