Individual retirement accounts (IRAs) are tax-advantaged vehicles designed to be used as an income source throughout your retirement years. Should you need money sooner, however, you can withdraw such funds at any age and/or time. Ideally, to maximize savings, you should not withdraw these funds before reaching retirement. However, things may occur that are beyond your control, and you may need income, leaving you no choice but to tap your IRA funds earlier than planned.

Accessing those funds early comes at a cost. In most cases, withdrawing funds before attaining age 59 ½ will be taxable (federal plus state, if applicable), and you will also be subject to a 10% early distribution penalty tax, unless certain conditions apply.

Currently, there are more than 20 exceptions to the 10% early distribution penalty tax. Importantly, some exceptions apply only to IRAs, whereas others apply to workplace retirement plans (i.e., 401(k)s), and lastly, some apply to both. For example, exceptions available only to IRAs (including SEP and SIMPLE IRA), are higher education expenses, funds used to purchase a first home, and health insurance expenses, if you are unemployed. Exceptions applicable to both employer-sponsored plans and IRAs include death, disability, Section 72(t), and medical expenses amounting to more than 7.5% of adjusted gross income.

We will discuss each individual exception including several new ones included in Secure Act 2.0 in our next column. But for now, we’ll focus on aspects of the 10% early distribution penalty tax. Here are some important points to know:

  • When an individual below age 59½ takes a withdrawal from his or her IRA or an employer-sponsored retirement plan (i.e., 401(k), 403(b)), a 10% early withdrawal penalty tax applies unless an exception is satisfied. The funds are also generally included in taxable income.
  • If you’re due to turn age 59½ later this year (2025) but take an IRA distribution earlier (prior to your 59½ birthday), your distribution will generally be subject to the 10% penalty tax. In other words, avoiding such penalty requires that an IRA owner take a distribution after their 59½ birthday.
  • The 10% penalty tax applies only to the taxable portion of your traditional IRA distribution. Whereas any distribution of after-tax funds (basis) from a traditional IRA would not be subject to such a penalty or income tax. IRA basis is reported on IRS Form 8606 “Nondeductible IRAs.”
  • The 10% penalty tax generally applies only to the taxable portion (i.e., earnings) of a distribution from a Roth IRA. Notably, such penalty also applies to a distribution of converted funds taken within five years from the year of a conversion (known as the “recapture tax”). The penalty would apply even though the Roth IRA distribution would not be subject to taxation because such taxes were previously paid in the year of the Roth IRA conversion.
  • Distributions from an inherited IRA are never subject to the 10% penalty tax. This holds true even if both the IRA owner (now deceased) and his/her beneficiary are under age 59 ½.

Tax Reporting

When you take a distribution from your retirement account, your IRA custodian sends you and the Internal Revenue Service (IRS) a copy of Form 1099-R “Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.” reporting your distribution. In addition to showing the distribution amount, Form 1099-R will reveal the distribution type. Furthermore, there is a code (code 2) that indicates whether there is a known exception to the 10% penalty tax indicating your distribution is not subject to this additional penalty tax. However, IRA custodians are not usually aware of whether you qualify for an exception. Therefore, in most cases, the 1099-R (that you receive) will indicate that there is no known exception to your distribution (code 1). Therefore, it’s up to you (or your accountant) to notify the IRS the 10% penalty tax doesn’t apply

How do you report that the 10% federal penalty tax doesn’t apply to your distribution? File IRS Form 5329 “Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts” along with your tax return.

Questions? Please contact your Lord Abbett representative at 888-522-2388.