This is the third in a multi-part series by Christopher M. Moore. Read Part 1 (PENALTY-FREE DISTRIBUTIONS FROM RETIREMENT PLANS BEFORE AGE 59½ : A WINDOW OF OPPORTUNITY) and Part 2 (Retirement Plan Interests as Community Property) The rules governing the taxation of retirement plan withdrawals may be summarized as follows:
- All such withdrawals are ordinary income for federal and state income tax purposes.
- An “additional” or penalty tax of 10 percent applies to distributions from qualified retirement plans to recipients under age 59½. Internal Revenue Code §72(t).
- The combined state and federal income tax, taking into account the deductibility of state income tax on the federal return, is approximately 34.8 percent in California. When the 10 percent penalty tax is added, the effective combined rate approaches 45 percent. In cases where the marginal federal tax rate is 33 percent rather than 28 percent, the combined tax rate, including the penalty tax, can approach 50 percent, The penalty tax, which is not deductible on either the federal or state tax return, can make withdrawals before age 59½ prohibitively expensive.
- Distributions made after the distributee attains age 59½ Code §72(5)(2)(A)(i).
- A series of substantially equal periodic payments made at least annually for the life or life expectancy of the distributee. Code §72(t)(2)(A)(iv).
- Distributions which do not exceed the allowable deduction for the distributee’s medical expenses under Internal Revenue Code §213. Code §72(t)(2)(B).
- Certain distributions from ESOP’s. Code §72(t)(2) (C).
- Any distribution to an alternate payee pursuant to a QDRO. This exception, however, does not apply to distributions from an IRA. Subsection (3)(B) of Code §72(t) provides that periodic payments from qualified plans must begin after separation.