Distributions from a qualified retirement plan prior to the participant reaching age 59½, that are not rolled over, are subject to taxation and a 10% penalty. However, the law allows several exceptions to the penalty, including:
- Substantially equal periodic payments after separation from service (72(t) distribution)
- Separation from service during or after the year the participant attains age 55
- Qualified Domestic Relations Order (QDRO)
- Corrective distributions
- Unreimbursed medical expenses
- IRS levy
- Dividends paid with respect to certain stock held by an ESOP
- Individuals called to active duty
- Special automatic enrollment rules
- Birth/adoption of child
The following provides greater detail for each of these penalty exceptions:
Upon the death of the plan participant, assets distributed from the plan to beneficiaries qualify as an exception.
Under the Internal Revenue Code, an individual is considered disabled if he or she is unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or to be of long-continued or indefinite duration. The participant must furnish proof of the disability in the form and manner required by the IRS.
SUBSTANTIALLY EQUAL PERIODIC PAYMENTS AFTER SEPARATION FROM SERVICE (72(T) DISTRIBUTION)
Also qualifying are a series of substantially equal periodic payments (calculated by one of three methods prescribed by the IRS) based on the life or life expectancy of the ex-employee or over the joint lives or joint life expectancies of the ex-employee and the ex-employee’s beneficiary.
Payments must continue unchanged for five years or until age 59½, whichever is later. Altering these payments results in the penalty, plus interest, on all distributions; however, the five-year rule is waived upon death or disability.
SEPARATION FROM SERVICE DURING OR AFTER THE YEAR OF ATTAINING AGE 55
The penalty is waived for distributions from a plan after separation from service and separation occurs during or after the year the employee attains age 55; for example, a 54-year-old taking a distribution is not subject to the penalty if she separates from service in the calendar year she turns 55. This rule applies only to distributions from a qualified plan in which you separated service and no longer waives the penalty when assets are rolled into an IRA or another qualified plan.
QUALIFIED DOMESTIC RELATIONS ORDER (QDRO)
Distributions to an alternate payee (a spouse, former spouse, child, or other dependent of a participant) pursuant to a QDRO (a judgment, decree, or order that relates to child support, alimony payments, or marital property rights for the benefit of an alternate payee) would also not be subject to the penalty.
The waiver applies to corrective distributions of the following if made timely:
* Highly Compensated Employees include: 1) a 5% owner of the employer, or 2) an employee earning > $135,000 (2022) in the prior year (and, if employer elects, in the top 20% of employees as ranked by pay). All other employees are considered Non-Highly Compensated.
- Excess contributions: Highly Compensated Employee* (HCE) deferrals that exceed the limits of the Actual Deferral Percentage (ADP) test;
- Excess deferrals: Deferrals that exceed the individual limits of $20,500 or $27,000 (2022), which includes a $6,500 “catch-up”; and
- Excess aggregate contributions: HCE matching and/or “after-tax” (not Roth) contributions that exceed the limits of the Actual Contribution Percentage (ACP) test.
UNREIMBURSED MEDICAL EXPENSES
Distributions taken to pay medical expenses in excess of 7.5% of adjusted gross income (AGI), whether or not the individual itemizes deductions for the taxable year, qualify for the exception. Note: The medical expense payment and the plan distribution must occur in the same year.
Amounts debited from a qualified retirement plan as a result of an IRS levy are not subject to the penalty. Note that the wavier does not apply to distributions taken from a qualified retirement plan by a participant to satisfy the taxes owed in order to avoid the levy.
A DIVIDEND PAID WITH RESPECT TO CERTAIN STOCK HELD BY AN ESOP
Dividends paid in cash directly to ESOP participants by the employer and dividends paid to the ESOP and then distributed in cash to the participants also qualify.
QUALIFIED RESERVIST DISTRIBUTION
The exception applies to distributions made during the period beginning on the date an individual is called to active duty (for a period in excess of 179 days or for an indefinite period) and ending at the close of the active duty period.
AUTOMATIC ENROLLMENT (“AUTO-ENROLL”) RULES
Automatic employee contributions under an Eligible Automatic Contribution Arrangement (EACA) that are withdrawn within 90 days of enrollment will not be subject to the penalty.
PRESIDENTIAL DISASTER AREA RELIEF
Qualified disaster area relief distributions (during IRS specified periods and for specified maximum amounts) made to participants who suffered a loss as a result of a “major disaster” qualify for the exception.
BIRTH/ADOPTION OF CHILD
Up to a $5,000 ($10,000 if married filing jointly) withdrawal for childbirth or adoption expenses.
Ordinary Income Tax: While these exceptions eliminate the penalty, it is important to note that such distributions are still subject to ordinary income tax, if applicable.
Stifel does not provide legal or tax advice. Consult your legal and tax advisors regarding your particular situation. It is the plan participant’s responsibility to ensure the requirements of the penalty exception are met.