A distribution from a retirement plan is when the account owner withdraws money from the retirement account. The withdrawals might trigger a tax or penalty under certain circumstances. However, following some simple rules can help determine whether an individual’s distributions will be free of tax and/or penalty.
In general, there are three scenarios of distributions: normal distribution after the age of 59½, qualified early distribution and non-qualified early distribution (with the last two occurring before the age of 59½).
Distribution After 59½ Years Old – Normal
401K & Traditional IRA Distribution After 59½ Years Old
An individual can start withdrawing from their retirement plan but are not required to, when an individual reaches 59½ years old. However, when someone reaches the age of 72, the Required Minimum Distribution (RMD) begins to apply. An RMD is the minimum amount of money one must withdraw from a tax-deferred retirement plan. Once the individual reaches this milestone, they generally must take a RMD each year by December 31st, otherwise, a penalty of 50% of the undistributed amount will be imposed. The RMD amount that is calculated depends on the balance in the individual’s account alongside with their life expectancy being defined by the IRS.
Roth IRA Distribution After 59½ Years Old
The withdrawal of a Roth IRA after the age of 59½ is free of tax and penalty. In addition, the RMD rule does not apply for Roth IRA, which allows a person to keep the asset in the Roth IRA for as long as they want. However, the asset must stay in the Roth IRA account for at least 5 years before the first distribution. For instance, if an individual creates a Roth IRA at 58 years old and start distributing at 59½ years old, that individual will be charged a tax and penalty on their GAIN for non-qualified distribution. Be aware that the five-year rule of distribution is only applied to the portion of GAIN in Roth IRA; there are no restrictions and no penalties on withdrawing the portion of the initial contribution.
Distribution Before 59½ Years Old – Qualified Exception
401K Early Distribution Exception 1: Borrow from Your 401K (Loan)
A 401K may offer loans to participants, which means an individual can take a loan out from their own 401K account. In order to determine if a plan offers loans, check with the plan sponsor or the Summary Plan Description.
An individual should consider a few things before taking out a loan from their 401K plan:
- The borrowed amount doesn’t need to be reported for tax purposes (AKA tax-free). No tax reporting is required for the loan amount.
- There may be a loan processing fee that is charged by the 401K record keeping company. The interest rate is usually 1-2% above the prime rate.
- The amount of money a party can borrow is never taxed twice, but the interest they pay on the loan is. The reasoning behind this is that the tax law requires said party to pay themselves an interest with after-tax money. The amount of loan interest an individual can pay themselves is taxed again when it’s withdrawn down the road, when they begin distribution during retirement. The maximum loan amount the party could borrow from their 401K is 50% of their vested account balance or $50,000, whichever is less.
- For instance, if someone has $80,000 in their 401K account, they can loan out $40,000 maximum. If a person has $120,000 in 401K account, they could loan out $50,000 only.
- Repayment of the loan must occur within 5 years, and payments must be made in substantially equal payments that include principal and interest that are paid at least quarterly.
- A loan that is taken for the purpose of purchasing the individual’s principal residence may be able to be paid back over a period of more than 5 years.
- Loan repayments are NOT plan contributions.
Before one can decide to take a loan from their own retirement account, the individual should consult with a financial advisor, who will help them decide if this the best option.
401K Early Distribution Exception 2: Hardship Distribution
Generally, the amount an individual withdraws from their 401K plan before reaching 59½ years old is subject to income tax and an additional 10% tax penalty. However, there are certain exceptions that apply. The most common exceptions are listed below:
- Medical bills that exceed 7.5% of AGI
- A court order to pay funds to a spouse, child or dependent.
Traditional IRA Early Distribution Exception:
A Traditional IRA plan is similar to a 401K plan, which is subjected to a 10% penalty if distributed before 59½ years old. There are also some exceptions allowing you to withdraw money early without penalty:
- Qualified first-time homebuyers, up to $10,000
- Medical expense exceeding 7.5% of AGI
- Higher Educational Expense
Roth IRA Early Distribution Exception:
Roth IRA consists of two portions:
- Regular after-tax contributions – commonly called “basis”
- Earnings on contributions
The 1st portion, after-tax contributions, can be withdrawn at any time, for any reason, with no taxes or penalties.
The 2nd portion, earnings, may be subject to the regular income tax and an additional 10% penalty if withdrawn before 59½ years old.
Certain exceptions that are applied:
- First-time homebuyers
- Medical expense exceeding 7.5% of AGI
- Higher educational expense
Distribution Before 59½ Years Old – Penalty
In general, retirement plan early distributions that occur before 59½ years old will be subjected to the additional 10% tax penalty. The penalty will be exempt only if the qualified exceptions are applied.
There are consequences to consider before an individual makes unqualified early distributions for Roth IRA:
- The contribution of Roth IRA is after tax, which is different from 401K and Traditional IRA. Accordingly, the withdrawal from a Roth IRA isn’t taxable up to the amount of the individual’s original contributions, regardless of age.
- However, any gain earned from Roth IRA is subjected to tax and a 10% penalty if distributed before 59½ years old.
- For example, in the year 2021, a party contributed $6,000 to Roth IRA, and then withdrew $6,300 ($6,000 contribution + $300 gain) in the year 2022; only the $300 gain will be taxed.
- An Individual will receive a 1099-R from your IRA account brokerage firm, which will report a lump-sum distribution amount. As a taxpayer, the individual has to report their tax filing to identify the allocation between the contribution and gain, based on which the penalty will be charged.
The Bottom Line
Like any retirement account, it’s important to keep the money invested as long as one can. The longer the money can stay invested and grow, the better off the individual will be. One must consider talking to a financial advisor first to see how it will impact their future if they plan to use their retirement funds.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.