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.

Disability

If you begin to receive payments because you are totally and permanently disabled, the distributions are not subject to the additional tax on early withdrawals.

Distributions Made After Employee’s Death

Distributions made upon the participant’s death are not subject to the additional tax.  But you will need to review the minimum distribution requirements in the event of an employee’s death.  These are explained below in the Tax on Excess Accumulation section.

Exceptions for Qualified Retirement Accounts

These exceptions generally apply to plans through your employer.  The following distributions would not be subject to the additional tax on early withdrawals:

• Distributions made after your separation from service in the year you reached the age of 55 or later.
• Distributions made to an alternate payee under a qualified domestic relations order (court-ordered child support, alimony, or marital property rights).
• Distributions to the extent you have medical expenses that exceed 7.5% of your adjusted gross income, regardless of whether you actually itemize deductions
• If as of March 1, 1986 you had separated from service and had started receiving payments under a written election providing for a specific schedule of distributions of your entire interest in the plan.
• Payments of dividends on securities held in an employee stock ownership plan.
• Distributions due to an IRS levy of the plan.

Exceptions for Nonqualified Annuity Contracts

These exceptions apply to retirement plans in the form of annuity contracts, that do not meet the requirements for qualified retirement accounts (above):

• Distributions from a deferred annuity contract, of amounts invested in the contract before August 14, 1982.
• Distributions under a personal injury settlement from a qualified annuity contract.
• Distributions from a qualified annuity contract that your employer purchased when it terminated a qualified employee plan or a qualified employee annuity plan, and that were held until your separation from service.

Tax on Excess Accumulation

The intent of the tax on excess accumulation is to ensure that taxpayers receive most of their retirement benefits during their lifetime.  In order to avoid this tax, you must begin receiving payments from a qualified retirement plan no later than your “required beginning date”, and the payments you receive cannot be less than the required minimum distribution.

Required Beginning Date

In avoid to avoid the additional tax, you must start receiving distributions from a qualified retirement plan by April 1 of the year following the calendar year in which:

• you reach age 70 1/2 , or
• you retire from employment with the employer that maintains the retirement plan.

But if you are 70 ½ or older and have not yet retired, but the plan requires you to start receiving distributions by April 1 of the year following the calendar year in which you reach age 70 ½, that will be your required starting date.

Also, if you are at least a 5% owner of the company that maintains the retirement plan, you must start receiving distributions by April 1 of the year following the calendar year in which you reach age 70 ½, regardless of when you retire.

Required Distributions

By the required starting date, you must receive either:

• Your entire interest in the plan, or
• Periodic distributions, such that the annual amounts are calculated to distribute your entire interest over your life or life expectancy, or over the joint lives or life expectancies of you and a designated beneficiary.  You can receive periodic distributions over a shorter period of time.

Tax on Distributions Not Made

If you do not receive the minimum required distributions, or receive less than the required amount, you could be subject to a 50% excise tax on the amount of the required distribution that was not made.

Annual Distributions

After your starting year (the year you retire or reach age 70 ½, whichever applies for purposes of your required starting date) you must have received at least the minimum required distribution for that year by December 31.  For your starting year, the deadline is April 1 of the following year, so the following year you would have to receive two minimum distributions, one by April 1 for the prior year which was your starting year (if it was not made by December 31 of your starting year), and another by December 31, that corresponds to the current year.

Distributions After Employee’s Death

If an employee dies while receiving periodic distributions, any balance remaining at the date of death must continue to be distributed to the employee’s designated beneficiary at least as rapidly as the distributions were being made to the employee.

If the employee dies before the required beginning date, there are two rules that apply in determining the distribution required in order to avoid the additional tax.  The terms of the retirement plan determine which rule applies.  The plan may allow the employee or beneficiary to choose which rule will apply.  In this case, the choice must be made by the earliest date a distribution would be required (generally December 31 of the year following the year of the employee’s death).

If the plan does not specify a rule, does not allow a choice, or if a choice is not made, rule 2 would apply if the employee has a designated beneficiary.  If not, rule 1 would apply.

Rule 1:   Distributions must be completed by December 31 of the fifth year following the year of the employee’s death.

Rule 2:  The distribution must be made in annual amounts over the life or life expectancy of the designated beneficiary.  If the beneficiary is a surviving spouse, the distributions do not have to begin until December 31 of the year following the year in which the employee would have reached age 70 ½.

Types of Installments

Distributions, for purposes of avoiding the additional tax, are defined in annual amounts.  The actual distributions can be made in monthly or quarterly installments, and as long as the total distributions for the year are more than the required minimum amount, and have been made by the required date, the additional tax can be avoided.

Distributions for More than the Minimum

You can receive more than the minimum amount required in any year, but the excess you receive in one year cannot be carried forward to be used to meet the minimum required distribution in any future year.

Combining Accounts to Meet the Minimum

If you have more than one pension fund, the minimum required distribution is calculated on each account separately.  You must meet the minimum distribution requirements of each plan individually.

How To Report

If you owe either the tax on early withdrawals or the tax on excess accumulation of pension funds, you will need to file Form 5329, Additional Taxes on Qualified Plans (including IRAs) and Other Tax Favored Accounts.

The additional tax on early withdrawals is calculated in Part I of Form 5329, and the excise tax on excess accumulations (not receiving minimum required distributions) is calculated in Part VIII.  Both Form 5329 and the instructions can be downloaded from the IRS website.

Reporting Exceptions for Early Withdrawals

If an exception to the additional tax on early withdrawals applies, and your employer or other payer of the distribution  knows of the exception, there should be a distribution code of 2, 3 or 4 shown in box 7 on your From 1099-R.  In this case, you would not owe the additional tax and would not have to file Form 5329.  If an exception applies, but the payer of the distribution did not know about it, a code 1 will be shown in box 7 of Form 1099-R, indicating that an early distribution was made, with no known exception.  In this case, you would have to file Form 5329, report the taxable amount of the distribution shown in box 2a of Form 1099-R on line 1 of form 5329, and then on line 2, enter the amount that can be excluded and the corresponding exclusion number.  These are included in the instructions for Form 5329. 

Incorrect Distribution Code