couple discussing early retirement distributions with financial advisor in office
couple discussing early retirement distributions with financial advisor in office

Considering an early retirement distribution? Here are 10 things you need to know.

In tough economic times, many once-thriving business owners find themselves needing to tap into their tax-deferred retirement savings to make ends meet or cover a large bill. It happens more often than many people think, and it’s precisely why the IRS has rules for early retirement distributions.

If you find yourself in the situation of needing to tap your retirement savings, it’s crucial to understand how to handle the distributions properly.

Here are ten important reminders from the IRS to keep in mind:

  1. Understanding early distributions: If you take payments before age 59 ½ from your Individual Retirement Account (IRA), 401(k), or other retirement savings vehicle, they’re generally considered early or premature distributions. This classification carries specific tax implications.
  2. The 10% additional tax: Early distributions typically incur an additional 10% penalty tax on top of regular income taxes. Remember, your contributions were made pre-tax, meaning that you’re tapping tax-deferred income.
  3. Reporting requirements: It’s essential to report early distributions to the IRS. Make sure to provide your accountant with Form 1099-R, as the IRS cross-references this information with your tax return.
  4. Rollovers and avoiding the 10% tax: Rolling over distributions to another IRA or qualified retirement plan within 60 days can help you avoid the 10% additional tax. This is especially useful if you’re changing jobs and need to move your 401(k) into an IRA. Don’t abandon your hard-earned savings! 
  5. Taxation on rolled-over amounts: While rolling over defers immediate taxation, the funds will eventually be taxed when the new plan distributes them to you or your beneficiary.
  6. Nondeductible contributions: If you made nondeductible contributions to your IRA, early distributions from those contributions are not taxed, preventing double taxation. You’ll only be taxed on the earnings (unless it’s a Roth IRA—you contribute post-tax dollars to a Roth IRA, and your earnings are not taxed).
  7. Roth IRA distributions: Early distributions from a Roth IRA that are attributable to your prior contributions are not taxed. This is because Roth contributions are made with after-tax dollars.
  8. Qualified retirement plan distributions: Generally, distributions from other qualified retirement plans are fully taxable unless you made after-tax contributions.
  9. Exceptions to the 10% Tax: There are several exceptions to the additional 10% tax on early distributions, offering some relief in specific situations. These exceptions include:
    • First-time home purchase: You can use up to $10,000 of your IRA funds penalty-free for buying or building a first home.
    • Qualified medical expenses: If your unreimbursed medical expenses exceed 7.5% of your adjusted gross income (AGI), early distributions used to cover these costs are exempt from the 10% penalty.
    • Higher education costs: Expenses for tuition, fees, books, and supplies for yourself, your spouse, children, or grandchildren can qualify for an exception.
    • Disability: If you become totally and permanently disabled, you can access your retirement funds without incurring the additional tax.
    • Health insurance premiums: If you’re unemployed, you may use early distributions to pay for health insurance premiums without facing the penalty.

If you have taken early distributions for any of these reasons, be sure to inform your accountant. Providing detailed information about your medical expenses or education costs, especially if they don’t fully meet other credit or deduction thresholds, could help you avoid the 10% early distribution tax. Doing so can result in significant savings and better financial planning during challenging times.

  1. Further information: For detailed guidance on early distributions, the additional 10% tax, and applicable exceptions, refer to IRS Publication 575 (Pension and Annuity Income) and Publication 590-a (Individual Retirement Arrangements). Of course, your accountant is always just a call away to help navigate these complexities.

We hope this helps you better manage early retirement distributions and avoid unnecessary tax penalties. If you have any questions or need personalized advice, don’t hesitate to reach out to our team. We’re here to help you make the most of your financial decisions, even in challenging times.

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