Distribution Rules, Alternatives And Taxation - Penalties
As a general rule, a withdrawal from a tax-advantaged retirement plan prior to the participant reaching the age of 59.5 results in a tax penalty equal to 10% of the withdrawal amount. This penalty is in addition to ordinary income tax due on the withdrawal.
Withdrawals permitted at any time
Early withdrawals from the following types of plans are permitted at any time, subject to the 10% penalty:
Withdrawals only after leaving employment
Early withdrawals subject to 10% penalty from the following types are allowed only after severance from employment:
Exceptions to Penalties
Loans – Certain employer-sponsored retirement plans may allow participants to borrow funds from their individual accounts without incurring the 10% penalty, provided they adhere to an approved repayment plan. The loan feature is at the option of the plan sponsor and is not mandatory.
Plans permitted to allow loans:
§ Governmental 457 plans (Not 457 plans sponsored by tax-exempt organizations.)
§ Defined benefit
Plans not allowing loans:
§ SEP IRAs
§ SIMPLE IRAs
Hardship Withdrawals – Certain employer-sponsored retirement plans may allow participants to withdraw funds "on account of an immediate and heavy financial need of the employee, and the amount must be necessary to satisfy the financial need."
Hardship definition - Expenses deemed to be "immediate and heavy" include:
§ Certain medical expenses.
§ Costs relating to the purchase of a principal residence.
§ Tuition and related educational fees and expenses.
§ Payments necessary to prevent eviction from, or foreclosure on, a principal residence.
§ Burial or funeral expenses.
§ Certain expenses for the repair of damage to the employee's principal residence.
§ A distribution is not considered necessary to satisfy an immediate and heavy financial need of an employee if the employee has other resources available to meet the need.
Plans permitted to allow hardship withdrawals:
457 Plans – These types of plans are unique in that withdrawals are permitted upon severance from the employer. There is no early withdrawal penalty for withdrawing funds prior to age 59.5 if the participant is no longer employed by the plan sponsor.
Substantially Equal Periodic Payments (SEPP)
This is a method that allows individuals who have invested in an IRA, or another qualified retirement plan, to withdraw funds prior to the age of 59.5 without incurring the 10% early withdrawal penalty. This method sometimes is also referred to by the relevant section of the tax code as Rule 72(t). Ordinary income tax would still be due on the withdrawals. The individual must receive at least one payment a year for five years or until the individual reached 59.5, whichever is longer.
Terminations of a SEPP plan before the deadline will be result in all of the penalties that were waived on amounts taken under the program, plus interest. The IRS allows an exception to this rule for taxpayers who terminate the program because they become disabled, die or the retirement assets under the SEPP are depleted due to a loss in market value.
Plans Eligible for Substantially Equal Periodic Payments
IRAs – May begin substantially equal periodic payments at any time.
Qualified plans and 403(b) plans – Substantially equal periodic payments not allowed while still employed by the plan sponsor.
Three Payment Calculation Methods – There are three IRS-approved methods for calculating substantially equal payments.
- Required minimum distribution (RMD) - The annual payment for each year is determined by dividing the account balance for that year by the life expectancy factor of the taxpayer and beneficiary, if applicable. Under this method, the annual amount is required to be figured again each year, and, as a result, will change from year to year. This method takes into account market fluctuations of the account balance. Generally, results in the smallest amount of the three methods.
- Amortization - Under this method, the annual payment, which is the same for each year of the program, is determined by using the life expectancy of the taxpayer and the beneficiary, if the taxpayer has one, and a chosen interest rate. This is the most complex calculation, but is only needed to be performed once.
- Annuitization - Similar to the amortization method, the amount under this method is the same each year. The calculation is performed just once. The amount is determined by using an annuity based on the taxpayer's age and the age of the beneficiary, if applicable, and a chosen interest rate. The annuity factor is derived using an IRS-provided mortality table.