10 Percent Early Distribution Penalty Tax Exceptions
By Cindy Fairchild, QKA, CIP
Are the 10 percent early distribution penalty tax exceptions the same for all types of retirement accounts?
Some exceptions apply universally across both qualified retirement plans (QRPs) and individual retirement accounts (IRAs). Some exceptions, however, are unique to QRPs and some are unique to IRAs.
Universal exceptions include attainment of age 59½, death, disability, substantially equal periodic payments (also known as 72(t) payments), IRS levies, medical expenses, qualified reservist distributions, and qualified birth or adoption distributions.
Exceptions that are unique to QRPs include alternate payee distributions, corrective distributions, ESOP dividends, life insurance premiums, and separation from service after age 55.
Exceptions that are unique to IRAs include first-time homebuyer expenses, health insurance premiums following unemployment, and qualified higher education expenses.
Note that these are high level definitions. Each penalty tax exception has specific conditions that account owners must meet before they can have the penalty tax waived. Additional information on the exceptions can be found on the IRS’s website.
If the 10 percent early distribution penalty tax applies, is it deducted from the distribution when it’s processed?
No, the penalty tax will be applied to the account owner’s total tax liability when he files his federal income tax return for the year in which the distribution was taken.
If an account owner is eligible for a penalty tax exception, but Box 7 of Form 1099-R does not reflect an exception code, how should the account owner claim the exception?
The account owner should complete and attach Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts, when she files her federal income tax return. Line 2 includes a field to report the appropriate exception number that applies and the dollar amount that is eligible for the penalty tax exception. The applicable exception number can be found in the Form 5329 instructions.
Do the same rules apply if an account owner takes 72(t) payments from a QRP vs. an IRA?
Generally, yes. But there is one difference: while IRA owners may take 72(t) payments at any time, plan participants may take 72(t) payments only after they have separated from service. All other rules apply to both IRAs and QRPs—including using IRS-approved calculation methods, taking payments for a specified period of time, and limiting account modifications once payments have begun. Additional information on 72(t) payments can be found at the IRS’s website.
