Individual retirement accounts and 401(k) plans receive preferential treatment from the Internal Revenue Service. The IRS has specific rules regarding qualified distributions, and penalties apply for early withdrawals as these accounts are meant to provide financial security after retirement. Because contributions to the plans may be taxed at different times, distributions from the plans are based on the type of account.
A 401(k) plan allows employees to make voluntary, tax-deferred contributions to the plan, and employers may choose to contribute to the plan as well. Specific rules apply to distributions from these plans. If the employee retires, changes jobs or becomes disabled, he may withdraw his money. The employee’s beneficiary may receive a distribution if the employee dies. If the employer discontinues the plan and makes no provisions for another plan, the employee may take a distribution. Except for instances involving the death or disability of the employee, early distributions taken before age 59 1/2 are typically subject to a 10 percent penalty tax unless the money is rolled into another qualified plan, such as an IRA or another 401(k). However, employees who are at least 55 years of age may be exempt from this tax if they are no longer employed by the company sponsoring the plan, regardless of whether they do a rollover.
Traditional IRA account holders must begin taking required minimum distributions no later than April 1 in the year after they reach age 70 1/2. Distributions may begin during the year the IRA owner reaches that age, though it's not required. If required distributions are not taken, the account holder may be subject to a 50 percent tax on the distribution amount that was not withdrawn on a timely basis. If the account owner dies before reaching the age of 70 1/2, the required minimum distribution rules do not apply. Each year, the account holder must compute his required minimum distribution or RMD. The computation requires the use of life expectancy tables furnished by the IRS. The balance remaining in the account on Dec. 31 is divided by the distribution period, based on the life expectancy tables. If an amount greater than the RMD is withdrawn during any year, the account holder cannot claim the excess when figuring his distribution for the subsequent year. In other words, if he takes an excess distribution, he must add the excess to his year-end balance for purposes of the computation. Normally, withdrawals from traditional IRAs are taxed in the year that the money is received. Distributions are exempt from this rule if the funds are rolled over into another qualified plan, paid directly to a qualifying charitable organization or paid directly into the account holder’s Health Savings Account. Such transfers to HSAs are normally limited to one during the account holder’s lifetime.
Contributions to a Roth IRA are taxed when the money is earned, and for this reason, qualified withdrawals of contributed amounts are not taxed when the money is withdrawn. To be a qualified distribution, the withdrawal must occur at least five years after the owner's first Roth IRA was opened and funded. In addition, the owner must be at least 59 1/2 years of age or disabled, or the distribution must be used to purchase a first home -- otherwise any gains in the account, but not the contributions, will face a 10 percent penalty plus tax. First home distributions are limited to $10,000, but the money may be used to pay eligible costs for parents, children and grandchildren who are first-time home buyers as well as for the benefit of the account owner and his spouse. Roth IRA owners are not required to take minimum distributions at any age; but if the owner dies, his beneficiaries are subject to different rules. All interest earned by the IRA must be withdrawn no later than the end of the fifth year following the owner’s death. If the payments are based on the life expectancy of the beneficiary, this rule does not apply.
SIMPLE and SEP IRAs
Most of the rules that apply to distributions from traditional IRAs also apply to Simplified Employee Pension IRAs, or SEPs, as well as Savings Incentive Match Plans for Employees, or SIMPLE IRAs. One exception concerns the penalty tax on early withdrawals from SIMPLE IRAs. If the distribution occurs within two years of the date of the employee’s first participation in the plan, a penalty tax of 25 percent rather than 10 percent is assessed.
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