This is a reminder that not all 10% early distribution penalty exceptions apply to all retirement plan distributions. Here are the three biggest mistakes that we see.
Higher Education – From IRAs Only
Retirement funds can be used to pay for higher education expenses, but only when those funds come from an IRA account. This exception does not apply to distributions from employer plans. If you have made the mistake of taking funds from an employer plan and trying to use this penalty exception, don’t waste your time or money trying to get the IRS or the Tax Court to help you out. They can’t – because the law does not allow it – and they won’t. There are numerous court cases dealing with this issue and all individuals have lost.
Age 55 or 50 – From Employer Plans Only
There is an exception to the 10% early distribution penalty when a plan participant separates from service in the year they turn age 55. Distributions made to the plan participant from the employer plan are exempt from the penalty. Once the funds are moved to an IRA, that exemption is gone. When this mistake is made, again, don’t waste your time or money trying to get help. The IRS and the Tax Court cannot help you as the law does not allow it.
The age for this exception drops to age 50 for certain federal, state and local public safety employees. It only applies to distributions from their employer plans, not for distributions from IRA accounts.
QDRO – From Employer Plans Only
A QDRO is a qualified domestic relations order. It is used to split an employer plan in a divorce. The portion of the employer plan that the ex-spouse receives is often moved from the plan to an IRA in a non-taxable transfer. For the ex-spouse under the age of 59 ½, this could be a big mistake. Distributions from the plan to the ex-spouse are not subject to the 10% early distribution penalty. On the other hand, distributions from an IRA are subject to the penalty. Moving the funds from the plan to the IRA means that distributions prior to age 59 ½ would be subject to the penalty, if no other exception applies.
This is also a mistake that cannot be fixed. The decision to move employer plan funds to an IRA is an irrevocable decision that cannot be reversed – even if the employer plan would allow an ex-spouse of an employee to move the funds back to the plan.
Individuals under age 59 ½ and advisors need to be aware of the restrictions on the exceptions to the 10% early distribution penalty. Most of the exceptions come with some limits on the exception and, as you can see here, not all exceptions apply to all retirement accounts. Mistakes can be costly and generally cannot be fixed.