3969 / What is an early distribution from a qualified plan, and what penalties relate to it?

Except as noted below, amounts distributed from qualified retirement plans before the participant reaches age 59½ are early or premature distributions subject to an additional tax equal to 10 percent of the amount of the distribution includable in gross income.¹

To the extent that they are attributable to rollovers from a qualified retirement plan or a Section 403(b) plan, amounts distributed from Section 457 plans ( Q 3584) generally will be treated as distributed from a qualified plan, for purposes of the early distribution penalty.²

The 10 percent penalty tax does not apply to distributions:

(1)  made to a beneficiary, or the employee’s estate, on or after the death of the employee;

(2)  attributable to the employee’s disability;³

(3)  that are part of a series of substantially equal periodic payments made at least annually for the life or life expectancy of the employee or the joint lives or joint life expectancies of the employee and his or her designated beneficiary, and beginning after the employee separates from the service of the employer ( Q 3679);

(4)  made to an employee after separation from service during or after the year in which the employee attained age 55, or age 50 for distributions to qualified public safety employees from a governmental plan as defined in IRC Section 414(d);⁴

(5)  made to an alternate payee under a qualified domestic relations order ( Q 3915);

(6)  made to an employee for medical care, but not in excess of the amount allowable as a deduction to the employee under IRC Section 213 for amounts paid during the year for medical care, determined without regard to whether the employee itemizes deductions for the year;

(7)  made to reduce an excess contribution under a 401(k) plan ( Q 3808);

(8)  made to reduce an excess employee or matching employer contribution, that is, an excess aggregate contribution ( Q 3808);⁵

(9)  made to reduce an excess elective deferral ( Q 3760);⁶

(10)  that are dividends paid with respect to stock of a corporation described in IRC Section 404(k) (ESOPs) ( Q 3824);

(11)  made on account of certain levies against a qualified plan;⁷ or

(12)  that are qualified reservist distributions, which are distributions of elective deferrals made to reserve members of the U.S. military called to active duty for 180 days or more at any time after September 11, 2001. Reservists have the right to rollover the amount of any distributions to an individual retirement plan for two years following the end of active duty.⁸

(13)  made on account of qualified births or adoptions under the SECURE Act (see below for more details).

(14)   beginning in 2024, qualifies as an emergency distribution under the rules discussed below.

(15)   beginning in 2024, made on account of domestic violence if the participant certifies that they have been a victim of domestic violence by a spouse or domestic partner within the one-year period prior to the withdrawal (see below).

(16)   beginning in 2025, made to cover the costs of long-term care insurance (see below).

(17)   made on account of the taxpayer’s being diagnosed with a terminal illness.

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Planning Point: Note that many clients mistakenly believe that the penalty does not apply to certain distributions used to fund the purchase of the taxpayer’s home. This exception applies only with respect to IRA distributions—the 401(k) rules do not provide for a similar
exception.

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Planning Point: Early distribution penalties are generally waived in the event of natural disasters, and were waived in response to COVID-19-related distributions for 2020.

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The IRS has approved three methods for determining what constitutes a series of substantially equal periodic payments in the exception discussed in (3) above. If the series of payments is later modified, other than because of death or disability, before the employee reaches age 59½, or if after the employee reaches age 59½, within five years of the date of the first payment, the employee’s tax for the year in which the modification occurs is increased by an amount equal to the tax that would have been imposed in the absence of the exception, plus interest for the deferral period. For an explanation of the calculation under each method, the definition of “modified,” and related rulings, see Q 3679.

The exception for distributions pursuant to a QDRO (see (5) above) was not applicable where a participant took a distribution from the plan following a trade of other marital property rights for his or her spouse’s waiver of rights in his or her plan benefits.⁹

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Planning Point: A participant who separates from service during or after the year he or she attains age 55 but is not yet age 59½ should generally leave plan accounts in the plan if permitted rather than transferring or rolling the accounts to an IRA or other qualified plan. This allows the participant to take distributions from the account as permitted by the plan without being subject to the 10 percent tax. A transfer to an IRA would subject the money transferred to the 10 percent tax while a transfer to another qualified plan would subject it to the new plan’s restrictions on distributions and the 10 percent tax.

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A court determined that a distribution originating from an arbitration award was subject to the 10 percent penalty because the amounts attributable to the award were thoroughly integrated with benefits provided under the state retirement plan.¹⁰ The involuntary nature of a distribution does not preclude the application of the tax, provided that the participant had an opportunity, such as by a rollover, to avoid the tax.¹¹

The IRS has stated that the garnishment of an individual’s plan interest under the Federal Debt Collections Procedure Act to pay a judgment for restitution or fines as discussed in (11) above, will not trigger the application of the 10 percent penalty.¹²

The cost of life insurance protection included in an employee’s income ( Q 3948) is not considered a distribution for purposes of applying the 10 percent penalty.¹³ The Civil Service Retirement System is a qualified plan for purposes of the early distribution penalty.¹⁴

A plan is not required to withhold the amount of the additional income tax on an early withdrawal.¹⁵ Distributions that are rolled over ( Q 3996 to Q 4019) generally are not includable in income, and, thus, the 10 percent penalty does not apply. In the case of a distribution subject to 20 percent mandatory withholding, the 20 percent withheld will be includable in income, however, to the extent required by IRC Section 402(a) or IRC Section 403(b)(1), even if the participant rolls over the remaining 80 percent of the distribution within the 60-day period ( Q 4016). Thus, an employee who rolls over only 80 percent of a distribution may be subject to the 10 percent penalty on the 20 percent withheld.¹⁶

Qualified Birth and Adoption Distributions

The SECURE Act amended the IRC to allow qualified plan participants to withdraw up to $5,000 for a qualified birth or adoption without becoming subject to the 10 percent penalty on early distributions. The distribution must be taken within the one-year period following the birth or adoption.

IRS guidance clarifies that an “eligible adoptee” does not include the child of the participant’s spouse (in other words, step-parent adoptions do not count).¹⁷ Notice 2020-68 also clarifies that each parent is entitled to take a distribution with respect to the same child. Parents are also eligible to take distributions more than once—i.e., for multiple children over time. Parents of twins are entitled to double the $5,000 limit. However, plans are not required to provide the option for qualified birth or adoption distributions. If the plan permits distributions for qualified birth or adoption, it must also permit recontribution of those amounts.

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Planning Point: The SECURE Act 2.0 clarified that taxpayers who take penalty-free withdrawals for qualifying birth or adoption expenses do not have an unlimited amount of time to repay those amounts.  Instead, the repayment must be made within three years of the date of the withdrawal.  For qualifying birth or adoption withdrawals that were taken before the new law was enacted, the repayment period ends December 31, 2025.

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A qualified birth or adoption distribution is not treated as an eligible rollover distribution for purposes of the direct rollover rules of Section 401(a)(31), the notice requirement under Section 402(f), and the mandatory withholding rules under Section 3405. Thus, the plan is not required to offer an individual a direct rollover with respect to a qualified birth or adoption distribution. In addition, the plan administrator is not required to provide a Section 402(f) notice. Finally, the plan administrator or payor of the qualified birth or adoption distribution is not required to withhold an amount equal to 20 percent of the distribution, as generally is required in Section 3405(c)(1).

However, a qualified birth or adoption distribution is subject to the voluntary withholding requirements. If the plan does not permit qualified birth or adoption distributions and an individual receives an otherwise permissible in-service distribution that meets the requirements of a qualified birth or adoption distribution, the individual may treat the distribution as a qualified birth or adoption distribution on the individual’s federal income tax return. The distribution, while includible in gross income, is not subject to the 10 percent additional tax. If the individual decides to recontribute the amount to an eligible retirement plan, the individual may recontribute the amount to an IRA.

In the case of a recontribution made with respect to a qualified birth or adoption distribution from an applicable eligible retirement plan other than an IRA, an individual is treated as having received the distribution as an eligible rollover distribution (as defined in Section 402(c)(4))
and as having transferred the amount to an applicable eligible retirement plan in a direct trustee-to-trustee transfer within 60 days of the distribution.¹⁸

Emergency Distributions

Beginning in 2024, the SECURE Act 2.0 will also allow retirement plan participants to take emergency distributions from their retirement savings accounts without penalty (currently, a 10 percent penalty plus ordinary income tax applies if an early distribution does not qualify for an exception).

These emergency distributions will be limited to $1,000 each year.  Also, taxpayers who take emergency distributions must repay the distribution within a three-year period or will be prohibited from taking another $1,000 distribution during the following three-year period.  Non-highly compensated employees may be entitled to contribute the lesser of (1) 3 percent of compensation or (2) $2,500 to emergency savings accounts using after-tax dollars.

Long-Term Care Insurance

The SECURE Act 2.0 allows taxpayers to withdraw up to $2,500 each year to cover the costs of long-term care insurance without triggering the 10 percent early withdrawal penalty (these withdrawals will still be subject to ordinary income taxation).

The funds can be used to pay for standalone long-term care insurance or for certain life insurance or annuity contracts that also provide for meaningful financial assistance in the event that the insured person requires long-term care in a nursing home or home-based long-term care.

This new provision is effective for tax years beginning after December 31, 2024 (the $2,500 annual limit will also be adjusted for inflation).

Domestic Violence

Beginning in 2024, plan participants are entitled to take penalty-free withdrawals if the participant certifies that they have been a victim of domestic violence by a spouse or domestic partner within the one-year period prior to the withdrawal.  The withdrawal will be limited to the lesser of $10,000 (the amount will be indexed for inflation) or 50 percent of the participant’s vested account balance.  Plan participants who take advantage of this withdrawal provision will be permitted to repay the amounts withdrawn within three years.

Terminal Illness

Taxpayers who have been certified by a physician as being terminally ill will also be permitted to take penalty-free withdrawals beginning immediately (the withdrawals can also be repaid within three years).  The distribution is not exempt from income tax.

The IRS clarified that self-certification is not sufficient and the employee must provide evidence and documentation as required by the employer.  That evidence must include the certifying physician’s name and contact information, as well as a description of the evidence used to conclude that the individual suffers from a terminal illness.

The IRS also clarified that terminal illness means that the individual has been certified by a physician as having an illness or physical condition that can reasonably be expected to result in death in 84 months or less after the date of the certification.

While plans are not strictly required to offer the terminal illness exception, the employee may elect to treat an otherwise permissible in-service distribution as a distribution based on terminal illness via Form 5329, filed with their income tax return.¹⁹