Tax Issues with Early Distributions from Retirement Plans
Retirement plans are designed to promote saving for the golden years. This means there are lots of negative tax issues with early distributions from retirement plans and you better understand them.
Americans are infamous when it comes to saving for the future. Put simply, we fail miserably at it. The recent economic issues might change that, but I’ll hold off on predicting the future. Instead of trying to fight our failure to save, the government found a way to get around it.
We are bad at saving for the future, but we hate paying taxes more. Understanding this, the government has continually come up with retirement plans that give us a break on taxes so long as we regularly stick money in them. These plans have been a big success, which makes the government happy. Pursuing early distributions from retirement plans makes the government unhappy, which means there are tons of tax issues. Let’s look at some.
Any payment from a retirement plan before you reach the age of 59.5 years old is generally considered an early distribution. There are exceptions, but we will ignore them for the purpose of this article. These early distributions are disfavored by the government since it wants you to save. As a result, you take a tax beating.
How so? You are going to pay the regular income tax due on the distribution. You are then going to pay an additional 10 percent penalty. This ultimately means you could lose a huge percentage of the distribution to taxes, which pretty much defeats the purpose of taking it in the first place. Importantly, you can rollover your retirement savings from one plan to another without paying any tax penalties. Make sure to speak with your tax advisor to make sure you do it correctly.
As I am writing this in March 2009, things are very tough economically. You might be tempted to take a distribution from your retirement account to create a buffer against these uncertain times. Unless you absolutely are desperate, it probably will not make much sense because you will end up giving away so much money in taxes.