Tax Consequences of Taking an Early Distribution from an IRA

Individual Retirement Account (IRA) savings are intended to be for retirement only. If there comes a time prior to retirement when you need to withdrawal money out of your IRA it can be costly. If you take an early withdrawal, or early distribution as some people call it, before you reach age 59 1/2, you’ll be required to pay income tax on the amount and in some cases, penalties too.

Tax Consequences Before Age 59 1/2

Generally, if you withdraw money from your IRA before age 59 1/2 and you’re not rolling the money over to another IRA, you can expect to pay a 10% penalty on the amount. You’ll also have to pay income tax, since the amount you withdraw counts as taxable income. If you’re just taking a withdrawal to roll over the amount to a new IRA, you won't be required to pay the penalty and taxes, as long as you complete the rollover in 60 days.

Note that the IRS requires you to report any early distributions when filing your taxes. There are, however, a few situations where money may be withdrawn early without incurring the 10% penalty. These are a few of those:

• Funds used to pay a qualified tuition or education expense.
• Medical expenses for which you didn’t receive reimbursement.
• Should you experience unemployment, you can withdraw from your IRA to purchase medical coverage for you and your family.
• Certain military service personnel can take penalty-free withdrawals when they’re on active duty.
• Should you leave your job after you turn 55 years old, you may not be subject to the penalty.
• Other situations where you don’t have to pay the penalty include disability, death, and setting up an annuity.
• Because of special provisions for the year 2020, due to the Covid 19 Pandemic, under the CARES Act, you are allowed withdrawals of up to $100,000 per person without the usual 10 percent penalty

There are limits regarding how much you can withdraw for many of these scenarios where you’re exempt from paying the penalty.

Tax Consequences After Age 59 1/2

Once you reach age 59 1/2, you no longer have to worry about paying the 10% penalty should you start to take a distribution from your IRA. You will still have to pay income tax (assuming this was a tax-differed retirement account) on the amount you withdraw.

Once you turn age 70 1/2, though, you’re required to take distributions from your account. Taxpayers nearing age 70 1/2 should also keep in mind that failure to make the required withdrawals could result in a penalty of up to 50%.

Do I need to complete Form 5329 for my early distribution?

If you receive a distribution from a retirement account before you reach the age of 59½, you may have to pay a penalty, as well as the regular tax that is due on the withdrawn funds (which are treated as taxable income). The penalty is 10% of any amount withdrawn early unless you qualify for an exemption from the penalty.

Exemptions are available in many situations. You may be eligible for an exemption to the penalty if any of the following circumstances apply to your early distribution:

• You have unreimbursed medical expenses
• The distributions are not more than the cost of your medical insurance
• The distribution was made under a Qualified Domestic Relations Order (QDRO)
• You are disabled
• The distribution is a return of excess retirement contributions
• You are the beneficiary of a deceased IRA owner
• You are receiving distributions in the form of an annuity
• The distributions are not more than your qualified higher education expenses
• You use the distributions to buy, build or rebuild a first home (limited to $10,000)
• The distribution is due to an IRS levy of the qualified plan
• The distribution is a qualified reservist distribution

Important: Exemptions are not automatic in the above situations even if you qualify.

The Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts, can ensure your early distribution (or another specified tax situation) receives the proper tax treatment and help you avoid paying unnecessary taxes and penalties. Some taxpayers must file this whether or not they qualify for an exemption. The instructions for the form specify who must file it.

If you receive a 1099-R that does not show the correct code in Box 7 to indicate that you are eligible for an exception, you need to complete Form 5329 and file it with your 1040, 1040-NR or 1040-SR. If you do not file the form, you will have to pay the penalty that would otherwise apply to your early distribution from a traditional or Roth IRA, 401K or other qualified retirement plan.

You might also be required to complete if:

• The code in Box 7 is correct but the exception does not apply to the full amount of your distribution
• You received a taxable distribution from an education savings account or 529 Plan account
• You received a taxable distribution from an ABLE account
• You exceeded the maximum contribution limit to one or more tax-advantaged savings accounts
• You did not take the minimum required distribution from a qualified retirement plan