I took an Early Withdrawal from my Retirement Account. Now what?

On a regular basis I get clients who have taken a distribution out of their qualified individual retirement account or retirement plan before reaching 59 ½ years of age (the time when you can take a distribution and be subject to the 10% penalty). They do this before informing their bookkeeper, CPA, or attorney of their intent. This can trigger an additional tax on top of other income tax they may owe.

Early Withdrawals. An early withdrawal normally is taking cash out of a retirement plan before the taxpayer is 59½ years old. The IRS charges a 10 percent penalty on early withdrawals from most qualified retirement plans. There are many complicated exceptions to this general rule. So taxpayers should consult with their tax professional prior to taking a distribution.

For example, the additional tax does not apply to distributions due to an IRS levy of the plan. While the plan may be protected from creditors under state laws, a levy action by the IRS is a contested collection action that needs to be addressed by an experienced tax attorney.

The additional tax does not apply to nontaxable withdrawals. These include withdrawals of contributions that taxpayers paid tax on before they put them into the retirement plan (i.e., Roth contributions that meet time requirements). Other exceptions per IRC §§72(y)(2) et seq. include:

• qualified higher education expenses;
• qualified 1st time homebuyer (up to $10,000);
• amount of unreimbursed medical expenses greater than 7.5% of taxpayer’s AGI (or 10% of AGI after 2012 if under age 65);
• certain distributions to qualified military reservists called to active duty;
• if a qualified employee separates from service;
• and other exceptions that should be discussed with your tax professional.

Rollovers are also a nontaxable withdrawal. A “rollover” happens when a taxpayer takes cash or other assets from one qualified retirement plan and puts the money in another plan within 60 days. A rollover can also happen when they direct their plan administrator to make the payment directly to another retirement plan or to an IRA. The latter is the preferable procedure as the details of the transaction are fully reported to the IRS. The former procedure requires the taxpayer to monitor the 60-day period (no exceptions) and to keep records of the transaction to give to taxpayer’s tax return preparer as the IRS may only have information of one side of the transaction.

Be sure to notify your return preparer and ask questions before you sign your tax return. Best to get the advice up front rather than risk the IRS noticing you and perhaps looking deeper into your returns.

McFARLANE LAW – A Tax Law Firm
T.480.991.0032 / [email protected] / IRS & ADOR Tax Problem Resolution