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The Tax Perils of Early Retirement Distributions

Many people find it necessary to take out money early from their IRA or retirement plan. Doing so, however, can trigger an additional tax on top of the income tax they may have to pay. Here are a few key points to know about taking an early distribution:

  1. Early Withdrawals. An early withdrawal normally means taking the money out of a retirement plan before the taxpayer reaches age 59½.
     
  2. Additional Tax. If a taxpayer took an early withdrawal from a plan last year, the taxpayer must report it to the IRS. The taxpayer may have to pay income tax on the amount he or she took out. If it was an early withdrawal, the taxpayer may have to pay an additional 10 percent tax.
     
  3. Nontaxable Withdrawals. The additional 10 percent tax does not apply to nontaxable withdrawals. They include withdrawals of the taxpayer’s cost to participate in the plan. The cost includes contributions that the taxpayer paid tax on before he or she put them into the plan.

    A rollover is a type of nontaxable withdrawal. A rollover occurs when a taxpayer takes cash or other assets from one plan and contributes the amount to another plan. A taxpayer normally has 60 days to complete a rollover to make it tax-free.
     
  4. Check Exceptions. There are many exceptions to the additional 10 percent tax. Some of the rules for retirement plans are different from the rules for IRAs.
     
  5. File Form 5329. If a taxpayer took an early withdrawal last year, the taxpayer may need to file Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts, with the taxpayer’s federal tax return. See Form 5329 and its instructions for details.
     
  6. Use IRS e-file. Early withdrawal rules can be complex. IRS e-file is the easiest and most accurate way to file a taxpayer’s tax return. The tax software that a taxpayer uses to e-file will pick the right tax forms, do the math, and help the taxpayer get the tax benefits due. Seven out of 10 taxpayers qualify to use Free File, which is only available through the IRS website at www.irs.gov/freefile.

More information on this topic is available on www.irs.gov.

Cite: IRS Tax Tip 2016-32, 3/3/2016