United States
Hong KongThe 10 per cent penalty, and the exceptions that avoid it
A 10 per cent additional tax applies to distributions before 59½, with exceptions. Several apply only to IRAs and several only to employer plans, and knowing which is which is what the exam tests.
The penalty is straightforward. The exceptions are the topic, and they are not the same list for both account types.
Exceptions that apply to both
- Death of the account owner.
- Total and permanent disability.
- Substantially equal periodic payments.
- Unreimbursed medical expenses above the applicable AGI floor.
- An IRS levy on the account.
- Qualified reservist distributions.
- Certain federally declared disaster distributions.
- A limited birth or adoption distribution.
IRA only
- Qualified higher education expenses.
- First-time home purchase, up to a lifetime limit of USD 10,000.
- Health insurance premiums while unemployed.
Employer plan only
- Separation from service at age 55 or later - the rule of 55.
- Age 50 for qualified public safety employees.
- A qualified domestic relations order.
Separating at 56 and leaving the money in the employer plan gives penalty-free access. Rolling it to an IRA first destroys the exception, because the rule of 55 is an employer-plan provision. It is the classic trap in this topic.
Substantially equal periodic payments
A series of payments calculated under one of three approved methods, taken at least annually.
They must continue for the longer of five years or until age 59½. Stopping or modifying early triggers the penalty retroactively on every payment taken, plus interest.
Someone starting at 50 is committed until 59½, nearly a decade. Someone starting at 57 is committed for five years, to 62. That asymmetry is examinable.
What the penalty is not
It is an additional tax on top of ordinary income tax, not a replacement for it. A distribution of USD 20,000 at 45 in the 22 per cent bracket produces both the income tax and a further 2,000.
And an exception avoids the penalty only. The distribution remains taxable, which candidates sometimes forget when an exception applies.
Roth accounts
Ordering rules mean contributions come out first, tax and penalty free at any age. Converted amounts have their own five-year clock for penalty purposes. Earnings are the last out and are the part exposed.
Which makes a Roth IRA more accessible before 59½ than most clients realize, and it is worth saying to someone hesitating to contribute because they might need the money.
Contribution and benefit limits are indexed annually and several were changed by recent legislation. Confirm the current figure against the IRS before relying on it.
Common questions
What is the early distribution penalty?
A 10 per cent additional tax on distributions before 59½, on top of ordinary income tax rather than instead of it.
What is the rule of 55?
Separation from service at 55 or later allows penalty-free distributions from that employer's plan. It is 50 for qualified public safety employees and does not apply to IRAs.
Why should you not roll over before using the rule of 55?
Because the exception is an employer-plan provision. Rolling the balance to an IRA destroys it, and it is the most common trap in this topic.
Which exceptions apply only to IRAs?
Qualified higher education expenses, first-time home purchase up to a USD 10,000 lifetime limit, and health insurance premiums while unemployed.
How long must substantially equal periodic payments continue?
The longer of five years or until age 59½. Modifying or stopping early triggers the penalty retroactively on every payment taken, plus interest.