Penalty Tax on Early Distributions and Withdrawals

Retirement plans are not obligated to allow early withdrawals--that is, before age 59½--even for reasons of hardship. Allowing such withdrawals from a retirement plan does not disqualify the plan, but early withdrawals (as well as plan-initiated distributions) are subject to a 10 percent penalty tax unless :

• The participant becomes disabled;
  
  
• The participant dies and the distribution is made to the designated heir or heirs;
  
  
• The participant retires at or after age 55;
  
  
• The distribution is rolled over into another qualified plan or into an IRA;
  
  
• The distribution is made in the form of a lifetime annuity;
  
  
• The participant has medical expenses in excess of 7.5 percent of AGI and the withdrawal is less than that;
  
  
• The distribution is made to a current or ex-spouse following certain annulment, divorce, or separation orders;
  
  
• The distribution represents the dividends from employer securities within an ESOP.

Because the tax code exempts annuity payments from the penalty tax and defined-benefit plans usually distribute their benefits in the form of annuities, the tax applies primarily to withdrawals from defined-contribution plans. In 1997, over 40 percent of early distributions were not subject to the penalty tax (that figure excludes death or disability benefits and rollovers).⁽¹⁾ More than 80 percent of those early distributions were made by defined-benefit plans. By contrast, of the early withdrawals subject to the penalty tax, approximately 70 percent came from defined-contribution plans.

Penalty taxes also apply to early withdrawals from traditional IRAs and Roth IRAs, although the exceptions differ slightly from those noted here.