It’s common for clients to save for retirement throughout their careers, with many spending decades contributing to individual retirement accounts and 401(k)s plans.
The need to access retirement savings is also quite common even well before the client has reached retirement age. Life is unpredictable, and expenses can pile up — especially following a busy holiday season. However, early access to retirement funds is limited and can quickly become expensive.
It’s critical that clients who are considering tapping their retirement savings before age 59.5 understand the Internal Revenue Service rules on early withdrawals — and the significant penalties that can apply for both early IRA and 401(k) withdrawals.
Even when an exception to the early withdrawal penalty applies, the distribution still constitutes taxable income. The retirement plan will send the client a Form 1099-R upon distribution. Clients who are taking an early distribution should use Form 5329 to report the distribution and either report the amount of the penalty or claim an exception.
Early Withdrawal Penalties: The Basics
Taxpayers are entitled to contribute a limited amount of pretax dollars to their 401(k)s and IRAs each year, thereby reducing tax liability. To encourage those individuals to save the funds until retirement, a 10% early withdrawal penalty applies if the client starts withdrawing funds before age 59.5.
IRA owners can take distributions at any point, and for any reason. However, if an exception doesn’t apply and the taxpayer isn’t 59.5, the 10% early withdrawal penalty is tacked on to the ordinary income tax liability that any retirement withdrawal generates (Roth accounts are subject to different rules).
Clients can take distributions from 401(k) accounts only when certain events occur. For clients who have yet to reach age 59.5, it’s critical to determine whether an exception applies.
