7.15 Penalty for Distributions Before Age 59½
A 10% penalty generally applies to taxable distributions made to you before you reach age 59½ from a qualified corporate or self-employed Keogh plan, qualified annuity plan, or tax-sheltered annuity plan, but there are several exceptions. For example, the penalty does not apply to distributions made to you after separation from service if the separation occurs during or after the year in which you reach age 55. A full list of exceptions is shown below.
If no exception applies, the penalty is 10% of the taxable distribution. If you make a tax-free rollover (7.7), the distribution is not taxable and not subject to the penalty. If a partial rollover is made, the part not rolled over is taxable and subject to the penalty.
A similar 10% penalty applies to IRA distributions before age 59½ (8.12). The penalty is 25% if a distribution before age 59½ is made from a SIMPLE IRA in the first two years of plan participation (8.18). There is a penalty for pre–age 59½ distributions from deferred annuities (7.23). The penalty generally does not apply to Section 457 plans of tax-exempt employers or state or local governments. However, if a direct transfer or rollover is made to a governmental Section 457 plan from a qualified plan, 403(b) annuity, or IRA, a later distribution from the Section 457 plan is subject to the penalty to the extent of the direct transfer or rollover.
There are a few differences between the penalty exceptions shown below for qualified corporate and self-employed plan distributions and the exceptions for IRA distributions (8.12). There is no qualified plan exception for higher education expenses as there is for IRAs. On the other hand, the exception for distributions after separation from service at age 55 (or over) applies only to qualified plans and not to IRAs.
Exceptions to the penalty.
The following distributions from a qualified employer plan are exempt from the 10% penalty, even if made to you before age 59½. If the plan administrator knows that an exception applies, a code for the exception will be entered in Box 7 of Form 1099-R on which the distribution is reported.
Caution
- Rollovers. Distributions that you roll over tax free under the “direct rollover” or “personal rollover” rules (7.8) are not subject to the early distribution penalty.
- Disability. Distributions made on account of your total disability do not subject you to the early distribution penalty.
- Separation from service if age 55 or older. The early distribution penalty does not apply to distributions after separation from service if you are age 55 or over in the year you retire or leave the company. If you reach age 55 in the same year you separate from service, the distribution must be received after the separation from service but you do not have to turn age 55 before receiving the distribution; the exception applies so long as the distribution is received after the separation from service and you reach age 55 before the end of the same year. You cannot separate from service before the year you reach age 55, wait until the year you reach age 55, and then take a distribution; the penalty will apply because in the year of separation you were not at least age 55. As discussed below, the age test is reduced from 55 to 50 for qualified state or local public safety employees (police, fire fighting, emergency medical services). Note that the age 55 separation from service exception does not apply to IRA distributions. If you separate from service after age 55 and rollover a distribution to an IRA, the penalty exception will not apply to a distribution received before age 591/2 from that IRA. This happened to an attorney who left his law firm at age 56 and rolled over funds from the law firm’s pension plan to an IRA. The next year he withdrew about $240,000 from the IRA and was hit with the 10% penalty by the IRS. The Tax Court upheld the 10% penalty and also imposed a penalty for substantially understating tax (48.6). The Seventh Circuit affirmed. The appeals court was sympathetic to the taxpayer’s argument that it made no sense to impose the 10% early distribution penalty on the IRA distribution when he could have taken the distribution from his law firm’s plan at age 56 with no penalty, but that is how Congress wrote the law. The Courts cannot change the rules that allow the age 55 exception only for qualified plan distributions and not IRAs. The Seventh Circuit also upheld the substantial understatement penalty; the taxpayer had no authority for claiming that the penalty exception applied to his IRA distribution.
- Medical costs. Distributions are not subject to the early distribution penalty to the extent that you pay deductible medical expenses exceeding 7.5% of your adjusted gross income (whether or not an itemized deduction for medical expenses is claimed). After 2012, the AGI floor is scheduled to increase to 10% from 7.5% for taxpayers under age 65; see 17.1.
- Substantially equal payments. The early distribution penalty does not apply to distributions received after your separation from service that are part of a series of substantially equal payments (at least annually) over your life expectancy, or over the joint life expectancy of yourself and your designated beneficiary. If you claim the exception and begin to receive such a series of payments but then before age 59½ you receive a lump sum or change the distribution method and you are not totally disabled, a recapture penalty tax will generally apply. The recapture tax also applies to payments received before age 59½ if substantially equal payments are not received for at least five years. The recapture tax applies the 10% penalty to all amounts received before age 59½, as if the exception had never been allowed, plus interest for that period. However, the IRS allows taxpayers who have been receiving substantially equal payments under the fixed amortization or fixed annuitization method to switch without penalty to the required minimum distribution method; see Revenue Ruling 2002-62 for details. In private rulings, the IRS has allowed the annual distribution amount to be reduced without penalty after the account is divided in a divorce settlement.
- Beneficiaries. If you are the beneficiary of a deceased plan participant, you are not subject to the 10% penalty, regardless of your age or the participant’s age.
- Qualified reservist distribution. If you are a member of the reserves called to active military duty for over 179 days, or indefinitely, distributions received during the active duty period that are attributable to elective deferrals (401(k) or 403(b) plan) are not subject to the early distribution penalty. Furthermore, a qualified reservist distribution may be recontributed to the plan within two years after the end of the active duty period.
- Public safety employees separated from service. The early distribution penalty does not apply to a distribution from a state or local defined benefit pension plan to a public safety officer (police, fire, emergency medical) who has separated from service in or after the year of reaching age 50.
- IRS levy. Involuntary distributions that result from an IRS levy on your plan account are not subject to the early distribution penalty.
- QDRO. Distributions paid to an alternate payee pursuant to a qualified domestic relations court order (QDRO) are not subject to the early distribution penalty.
- TEFRA designations. Distributions made before 1984 pursuant to a designation under the 1982 Tax Act (TEFRA).
- Separation from service before March 2, 1986. Distributions to an employee who separated from service by March 1, 1986, are not subject to the early distribution penalty, provided that accrued benefits were in pay status as of that date under a written election specifying the payout schedule.
Filing Instruction
Financial hardship distributions or distributions used for college or home-buying costs are subject to the penalty.
The 10% penalty applies to a hardship distribution that you receive before age 59½ from a 401(k) plan (7.19) or 403(b) tax-sheltered annuity plan (7.21). Even where it is used to pay tuition costs or to buy a principal residence, there is no penalty exception, although a penalty exception generally applies for IRA distributions used for such purposes (8.12).
A hardship distribution used to pay medical costs may qualify for an exception; see above.
Corrective distributions from 401(k) plans.
If you are considered a highly compensated employee and excess elective deferrals or excess contributions are made on your behalf, a distribution of the excess to you is not subject to the penalty.
Filing Form 5329 for exceptions.
If your employer correctly entered a penalty exception code in Box 7 of Form 1099-R, you do not have to file Form 5329 to claim the exception. You also do not have to file Form 5329 if you made a tax-free rollover of the entire taxable distribution. You must file Form 5329 if you qualify for an exception, other than the rollover exception, that is not indicated in Box 7 of Form 1099-R.