Early Distributions and Penalty Tax Exceptions
IRAs and qualified retirement plans (QRPs) are intended to be used for retirement. Therefore, the tax laws and regulations encourage people to leave their money in an IRA or QRP until they retire. If distributions are taken from an IRA (including an IRA holding SEP contributions) or QRP before the account owner reaches age 59½, a 10 percent early distribution penalty tax is assessed on the taxable amount of the distribution, unless a penalty tax exception applies.
Unlike IRA and QRP distributions, SIMPLE IRA distributions are subject to a 25 percent early distribution penalty tax if distributed within a two-year period beginning on the date that the first contribution under the employer’s SIMPLE IRA plan is made to the employee’s SIMPLE IRA. The early distribution penalty tax does not apply if the IRA owner qualifies for a penalty tax exception.
The list of penalty tax exceptions has expanded in the last few years: some are only available to IRAs and some are only available to QRPs (SIMPLE IRA and SEP plan assets are subject to the same penalty tax exceptions as IRAs). Here is a list of the current available penalty tax exceptions, information on how they are reported, which ones can be repaid, and what forms taxpayers may need to file.
NOTE: The penalty tax exception is an exception to the 10 percent early distribution penalty tax imposed by the IRS, it is not an exemption from paying income tax on the IRA distribution.
Penalty Tax Exceptions for IRA and QRP Distributions
Tax laws provide the following penalty tax exceptions for IRA and QRP distributions under Internal Revenue Code Section 72(t). Individuals should consult with competent tax advisors to determine if they qualify for any penalty tax exceptions.
Early Distribution Penalty Tax Exceptions IRA and QRP
Age 59½
Death
Disability
Substantially Equal Periodic Payments
IRS Levies against retirement assets
Medical Expenses
Qualified Reservist Distributions
Qualified Birth or Adoption Distributions
Qualified Disaster Recovery Distributions
Terminal Illness Distributions
Domestic Abuse Distributions
Emergency Personal Expense Distributions
Early Distribution Penalty Tax Exceptions – IRA Only
Health Insurance Premiums Following Unemployment
First-Time Homebuyer Expenses
Qualified Higher Education Expenses
Early Distribution Penalty Tax Exceptions – QRP only
Separation from Service After Age 55
Distributions to an Alternate Payee
Dividends from ESOP Plans
Distribution Reporting Codes
Your financial organization must properly report the distributions on Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. Only a few penalty tax exceptions have specific distribution codes (see the table below). These codes generally require certification of the code before your financial organization can use it. For example, your financial organization should always receive a certified copy of a death certificate before using code 4 to report a death distribution. Your organization should also ask for proof of disability before using code 3 to report disability distributions. In certain other penalty exception circumstances, it is up to the taxpayer to claim, and file for, the exception.
For all other penalty tax exceptions, financial organizations should use
code 1 to report Traditional IRA distributions and QRP pretax and after-tax distributions,
code J to report Roth IRA distributions, and
codes B1 to report designated Roth distributions.
Distributions That Allow Repayment
Some distributions eligible for the 10 percent early distribution penalty tax exception allow a repayment of the distribution. The repayment amount cannot exceed the original distribution amount. Most of the repayment periods are three years from the date of distribution.
Qualified Reservist Distributions
No limit on distribution amount
Repayment permitted over a two-year period
Qualified Disaster Recovery Distributions
Available distribution amount is $22,000, per disaster
Repayment permitted over a three-year period
Qualified Birth or Adoption Distribution
Available distribution amount is $5,000, per individual, per event
Repayment permitted over a three-year period
No limit on distribution amount
Repayment permitted over a three-year period
Available distribution amount is the lesser of $10,300 (indexed) or 50 percent of the account balance, distribution must be taken within one year of the event
Repayment permitted over a three-year period
Account owners may take one penalty-free distribution per year that equals the lesser of $1,000, or an amount that equals the individual’s IRA balance (or vested benefit) minus $1,000 to pay for expenses related to an “unforeseeable or family emergency”
Repayment permitted over a three-year period
No additional distributions may be taken for emergency expenses within the following three calendar years unless the account owner repays the original distribution—or makes new contributions to the IRA or QRP in an amount at least equal to the portion of the original distribution that was not repaid.
NOTE: IRA owners can also roll over distributions taken to pay for first-time homebuyer expenses within 120 days of receipt if there is a delay or cancellation of the purchase or construction of the residence.
Reporting Repayments
Repayments are reported on Form 5498, IRA Contribution Information. Financial organizations should report the repayment of a qualified reservist distribution, a qualified disaster distribution, a qualified birth or adoption distribution, an emergency personal expense distribution, an eligible distribution to a domestic abuse victim, or a terminally ill individual distribution in Box 14a and use the corresponding code below in Box 14b.
Repayment codes
“QR” for a repayment of a qualified reservist distribution
“DD” for a repayment of a designated disaster distribution
“BA” for a repayment of a qualified birth or adoption distribution
“EP” for a repayment of emergency personal expense distributions
“DA” for a repayment of eligible distributions to a domestic abuse victim
“TI” for a repayment of terminally ill individual distributions
Taxpayer Forms for Penalty Exception and Repayment
Except in cases where the IRA custodian or plan administrator reports a distribution as exempt from penalty, an account owner must file Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts. Account owners may not take deductions for a timely repaid amount, and generally will refile a prior year’s income tax return to reclaim pretax status for the amount.
Account owners repaying qualified reservist distributions will report them on Form 8606, Nondeductible IRAs, because these repayments create after-tax basis in IRAs. Form 8915-F, Qualified Disaster Retirement Plan Distributions and Repayments, will be filed if the repayment is part of a qualified disaster distribution.
It is important for clients to understand the ramifications of IRA and QRP distributions. It is up to the client to know what does and does not count as a penalty tax exception. They should always talk to a competent tax advisor before taking a distribution.
