Early Distribution from Retirement Plans May Have a Tax Impact

Taking an early distribution from retirement plans—such as 401(k)s or IRAs—can significantly impact your tax situation. Here’s what you need to know about the potential tax implications:

Early Distribution Defined
An early distribution typically refers to withdrawing funds from a retirement account before reaching the age of 59½. The tax implications vary depending on the type of retirement account.

Potential Tax Implications

1. Income Tax

• Early distributions are generally subject to ordinary income tax. This means that the amount withdrawn is added to your taxable income for the year.
• Depending on your total income, this could push you into a higher tax bracket.

2. Early Withdrawal Penalty

• Most early distributions incur a 10% penalty tax on the amount withdrawn.
• There are exceptions where the penalty may be waived, such as for specific circumstances (e.g.,home purchase, qualified education expenses, certain medical expenses, disability, or if you are called to active duty).

3. State Taxes

• In addition to federal taxes, many states impose their own taxes on early distributions. Check your state tax laws for specifics.

Exceptions to the 10% Penalty
Certain circumstances allow you to avoid the 10% early withdrawal penalty while still paying regular income tax on the distribution. These exceptions include:
 

• Medical Expenses: If you have unreimbursed medical expenses that exceed 7.5% of your adjusted gross income (AGI).
• Disability: Withdrawals made due to permanent disability.
• Higher Education Expenses: Qualified higher education expenses for yourself or a dependent.
• First-Time Hone Purchase: Up to $10,000 for a first-time home purchase from an IRA.
• Substantially Equal Periodic Payments (SEPP): Taking regular distributions based on your life expectancy.
• Qualified Reservist Distributions: If you are a qualified reservist called to active duty.

Planning Considerations

• Assess Your Needs: Before taking an early distribution, consider other options for accessing funds, such as loans or other financial avenues.
• Understand Long-Term Impact: Early withdrawals reduce the amount of money available for retirement, which could impact your financial security in the long run.
• Consult a Financial Advisor: It’s beneficial to discuss potential tax implications and alternative solutions with a financial advisor or tax professional.

Reporting Early Distributions

• IRS Form 1099R: When you take a distribution from a retirement account, the financial institution will issue you a Form 1099R, reporting the distribution amount.
• Tax Return: You will need to report the distribution on your income tax return for the year. If applicable, you will also need to calculate and report the 10% penalty.