Monday, April 11, 2011

Did you Take an Early Distribution from Your Retirement Plan?

Tax laws encourages taxpayers to contribute to retirement plans whether it is a plan sponsored by their employer (typically a 401k) or an individual retirement arrangement (IRA). However, taking money out of these retirement accounts before age 59 ½ is considered an early distribution and can have some serious tax consequences in the form of an additional tax of 10% on the taxable part of the distribution.

The taxpayer will receive a Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. If the distribution code in box 7 is a code 1 (early distribution), the taxpayer will need to report the 10% penalty on line 58 of Form 1040.

If you change jobs, you may receive the total distribution of your retirement account and make a transfer to another qualified plan, this is known as a rollover. You can use a direct transfer from your old plan to the new plan (either your IRA or the employer retirement plan at your new job). If you choose to receive a cash distribution, it is taxable in the year you receive it unless you roll it over to a new plan within 60 days. Rollovers are not subject to the additional 10% tax.

For a Traditional IRA with nondeductible contributions, the portion of the distribution attributable to the nondeductible contributions is not taxed. If you received an early distribution from a Roth IRA, the distribution attributable to your prior contributions is not taxed. If the taxpayer received a distribution from any other qualified retirement plan, generally the entire distribution is taxable unless you made after-tax employee contributions to the plan.

In addition to a code 1 shown in box 7 of Form 1099-R, the following codes could trigger the 10% additional tax:
J - Early distribution from a Roth IRA
L - Loans treated as deemed distributions under section 72(p)
S - Early distribution from a SIMPLE IRA in first 2 years, no known exception

Several exceptions to the 10% additional tax include the following Form 1099-R distribution codes:
2 - Early distribution, exception applies
3 - Disability
4 - Death
7 - Normal distribution
8, D, P - Excess contributions plus earnings/excess deferrals in an employer plan
B - Designated Roth account distribution
E - Excess annual additions under section 415
G - Direct rollover and rollover contribution
H - Direct rollover of a designated Roth account distribution to a Roth IRA
Q - Qualified distribution from a Roth IRA
T - Roth IRA distribution, exception applies

Even if the taxpayer did receive a From 1099-R with a distribution code 1, the 10% additional tax maybe reduced or eliminated by completing Part I of Form 5329 Additional Taxes on Qualified Plans. This form covers the following circumstances (exception code is listed):
  • 01 - Distribution made to the taxpayer after employment termination occurred during or after the calendar year reaching age 55 (only applies to employer plans, not IRAs)
  • 02 - Distributions made as part of a series of substantially equal periodic payments over the taxpayer's life expectancy or joint life expectancy of taxpayer and beneficiary
  • 03 - Distributions made due to permanet and total disability
  • 04 - Distribution made to beneficiary due to death
  • 05 - Taxpayer paid excess medical expenses (exceeding 7.5% of Adjusted Gross Income) regardless of completing Schedule A Itemized Deductions. Ohio residents can take this deduction whether or not the taxpayer itemized deductions.
  • 06 - Qualified retirement plan distributions made to an alternate payee under a qualified domestic relations order (does not apply to IRAs)
  • 07 - Distributions made from an IRA to unemployed individuals for health insurance premiums
  • 08 - Distributions made from an IRA to pay for qualified higher education expenses for yourself, spouse, children, or grandchildren.
  • 09 - Distributions made from an IRA to pay for a first-time home for yourself, spouse, children, or grandchildren, up to $10,000.
  • 10 - The distribution is due to an IRS levy of the qualified
  • 11 - Qualified reservist distributions for an individual called to active duty after September 11, 2001 for a period of more than 179 days.
For more information, please refer to IRS Pub. 575 Pensions and Annuities and IRS Pub. 590 Individual Retirement Arrangements (IRAs). Make sure you understand the taxable implications before you receive your distribution.

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