U.S. federal income tax law provides certain tax benefits and incentives for saving for retirement. At the same time, the law encourages the intended use of retirement savings by imposing special additional taxes on early withdrawals of retirement funds, or the excess accumulation of pension funds once you reach retirement age.
Normally you will not be subject to the additional taxes for early withdrawals or excess accumulation of pension funds if you do not take any early withdrawals, or if you roll over any distributions you receive; and if you draw out reasonable amounts once you reach normal retirement age.
Tax on Early Withdrawals
You may be subject to an additional 10% tax on distributions you receive from qualified retirement plans and nonqualified annuity contracts before you reach the age of 59 ½. The tax applies to the amount of the distribution you would have to include in your gross income, and does not apply on any nontaxable portion, such as a return of your cost or investment in the plan or contract, or amounts you properly roll over into another retirement plan or IRA.
Which Retirement Plans are Subject to the Additional Tax
Qualified retirement plans, for this purpose, include qualified employee plans (including 401(k) plans), qualified employee annuity plans, and tax-sheltered annuity plans (403(b) plans). If any distribution from these plans is transferred or rolled over to a Section 457 deferred compensation plan for state and local government employees, early withdrawals from the Section 457 plan could also be subject to the additional tax.
Exceptions to the Additional Tax
There are some cases in which you will not have to pay additional tax on what would otherwise be considered an early distribution. There are general exceptions, exceptions that apply to qualified retirement accounts, and exceptions that apply to nonqualified annuity contracts.
General Exceptions
One of the general exceptions is that if you are receiving distributions as part of a series of “substantially equal periodic payments” for your life or your life expectancy, or the joint lives or life expectancies of you and your designated beneficiary, you are not subject to the additional 10% tax. These payments must be from a qualified retirement plan, and the benefits must begin after your separation from service. Payments qualify as “substantially equal periodic payments” if they are made according to one of the following methods:
Required minimum distribution method - the annual payment is re-determined each year by taking the balance in the account and dividing by the number from the life expectancy table.
Fixed amortization method or fixed annuitization method – the annual payment is determined for the first distribution year and then remains the same every year after that.