Exceptions to the 10% Penalty

They say you can never be too rich, too thin, or too young. Well, the Tax Code thinks there is such a thing as too young. Distributions from tax-favored retirement plans before age 59-1/2 are hit with an extra 10% penalty tax in addition to whatever regular income tax you will have to pay. Ouch. (That, of course, assumes you can get a distribution—see yesterday’s post).

When you’re young, there are lots of good reasons to delay distributions. But if you want or need to get at some of your tax-favored dollars, there are many exceptions to the 10% penalty. There are so many exceptions, it’s become the Swiss cheese of tax penalties. Here is a summary.

• Dotage. No penalty if you have already reached age 59-1/2.
• Death. No penalty on distributions to your beneficiary after your death, even if the beneficiary is under age 59-1/2 and even if you were under 59-1/2 when you died.
• Disability. No penalty on distributions made after you are disabled.
• Defer. No penalty on a distribution that is moved to another tax-favored retirement plan in a tax-free rollover.
• Double-tax. No penalty on the portion of the distribution that is not subject to income tax, e.g., because it represents a return of your own after-tax contributions, as described in February 15’s post. (There’s a special rule for Roth IRAs, but that’s a subject for another post.)
• Done. No penalty if you terminate employment with your employer after reaching age 55, and distributions from the employer’s plan begin after your termination of employment. This exception does not apply to a traditional IRA or a Roth IRA.
• Doled. No penalty if the distribution is part of a series of substantially equal periodic payments from the tax-favored retirement plan. This exception allows you to begin distributions at any age, facilitating early retirement if that is your goal, and facilitating emergency access to some of your retirement funds. This is a big one. It’s the only exception that is within your control. And it will be the subject of a future post.
• Divorce. No penalty on distributions to an Alternate Payee (e.g., your former spouse or a minor child) under a Qualified Domestic Relations Order. This exception applies to employer plans, but not to IRAs. If you don’t know what Alternate Payee and Qualified Domestic Relations Order mean, consider yourself lucky. It’s all about marital strife.
• Dorms. No penalty on traditional or Roth Individual Retirement Account distributions (but not employer plan distributions) up to the amount of your higher education expenses for you, your spouse, your children and your grandchildren.
• Domicile. No penalty on distributions of up to $10,000 from a traditional or Roth IRA (but not from an employer plan) used to pay for a first home for you, your spouse, your child or your grandchild.
• Disease. No penalty on distributions up to the amount of your and your dependents’ deductible medical expenses (i.e., to the extent they exceed 7.5% of your Adjusted Gross Income). Better not to qualify for this one.
• Dismissed. No penalty on distributions from traditional or Roth IRAs (but not from employer plans) up to the amount of your health insurance premiums after you have been unemployed for at least 12 weeks.
• Dividends. No penalty on dividends on employer stock paid out to Employee Stock Ownership Plan participants.
• Distributed shares. The Net Unrealized Appreciation (NUA) on employer securities distributed from an employer plan may be temporarily excluded from income tax at the time of distribution if certain requirements are met. If you qualify for that exclusion, then the NUA is also not subject to the 10% penalty tax. The whole NUA thing is a worthy subject for a future post.
• Deferrals. No penalty if your employer’s 401(k) plan distributes back some of your elective deferral in order to meet certain tests.
• Death wish. Some employer plans (but not IRAs) purchase life insurance for the benefit of its participants, and the value of that insurance protection is currently taxed to the participant. Nonetheless, the value of that insurance protection is not subject to the 10% penalty tax.
• Duty. No penalty if you are a reservist called to active duty in the armed forces.
• Distant past. If you terminated employment before March 1, 1986, then distributions from your employer’s plan (but not from traditional or Roth IRAs) that are being made in accordance with an election signed before March 1, 1986, are not subject to the 10% penalty.
• Debt. No penalty on distributions to the IRS to satisfy a federal tax lien. Big whoop.