By Kerri L. Tassin, JD

Now more than ever before, American workers save for retirement through 401(k) plans and Individual Retirement Accounts. According to a 2012 study conducted by the Society of Actuaries’ Pension Section Research Committee, between the years 1975 to 2005 the number of employees covered by defined benefit plans declined significantly, while participants in defined contribution plans, like 401(k) plans, rose greatly. Those of us planning for our retirement with the help of 401(k) plans and IRAs might benefit from learning some tax rules regarding these types of accounts.

Every year taxpayers with 401(k) plans or traditional IRAs run into unpleasant surprises at tax time. These particular taxpayers took distributions before reaching age 59 ¹/₂. They took these early distributions for a variety of reasons. Taxpayers may have used the funds to buy a car, invest in a business, put a down payment on a new home or simply pay for living expenses.

Frequently, although not always, these taxpayers understood that the distribution would likely be subject to income tax. They had no idea, however, that the early distributions could also be subject to an additional 10 percent penalty. Perhaps the taxpayer had an amount withheld from the distribution to cover the income taxes, but the withholding fell short of covering the penalty.

In many cases, the taxpayer must figure out a way to pay the additional tax, but in other instances, some exceptions to imposition of the penalty may apply.

Section 72 of the Internal Revenue Code provides for some exceptions to the 10 percent early distribution additional tax. Some of the exceptions for both 401(k) participants and IRA owners are quite similar. Generally speaking, an exception to the penalty may apply when the distribution is taken following the death or total and permanent disability of a 401(k) participant or an IRA owner. Also, the penalty may not apply in cases when the taxpayer takes the early distribution from either a 401(k) account or an IRA to pay for medical expenses in excess of 10 percent of adjusted gross income.

Other exceptions to the penalty apply to early distributions from IRAs, but not for early distributions from 401(k)s. For example, exceptions to the early distribution penalty may apply for taxpayers who use the funds from an IRA to pay for qualified higher education expenses, or health insurance premiums during periods that the taxpayer is unemployed. Qualified first-time home buyers may also take advantage of an exception to the penalty when up to $10,000 from an early IRA distribution is used to purchase a home. These exceptions to the 10 percent penalty do not apply in the case of early distributions from a 401(k) plan.

The Internal Revenue Code makes provisions for other exceptions to the early distribution penalty as well.

Taxpayers should do their homework before taking early distributions from a retirement plan such as a 401(k) plan or an IRA. Distributions taken before age 59 ¹/₂ may carry a disagreeable surprise in the form of an additional 10 percent tax penalty. In other cases, exceptions to the penalty may apply. And the type of retirement plan or account can make a difference. It’s a good idea to find out ahead of time whether an exception applies, and not during tax time.

The material in this article is for informational purposes only and does not constitute tax advice.

Please consult with your own tax adviser regarding your personal tax situation.

This article appeared in the November 22, 2014 issue of the Springfield News-Leader.  It is available online here.

Kerri Tassin, J.D., CPA, is director of the master of accountancy program in the School of Accountancy at Missouri State University. Tassin also is the director of the Volunteer Income Tax Assistance program and the director of the Low Income Tax Clinic at MSU. Email: kerritassin@missouristate.edu.