Learn about contributions, early withdrawal penalties, and distributions to help you avoid paying taxes on your IRA and 401(k) retirement funds.
Retirement accounts can be subject to tax penalties if rules aren’t followed carefully
Learn some retirement account mistakes to avoid
Look to limit penalties by understanding contributions, withdrawals, and distributions
Tax penalties usually occur when taxpayers don’t file returns or extensions or make other errors that raise red flags with the Internal Revenue Service (IRS).
But retirement accounts can also be subject to tax penalties if investors make mistakes. Christine Russell, senior manager of retirement and annuities at TD Ameritrade, likens this to Goldilocks and the three bears.
“You have withdrawal penalties for trying to take out your money too quickly when you’re too young. Then you have a penalty if you leave your money in too long when you’re old. So, you have to hit that sweet spot to avoid penalties,” Russell said.
The premature distribution penalty is 10%. That penalty applies when people who are younger than 59 1/2 take money out of their retirement accounts and spend it. This applies to both traditional individual retirement accounts (IRAs) and 401(k)s. Of course, making a valid rollover is an exception to the 10% penalty tax, so if you do get a payout of 401(k) or IRA benefits, consider the rollover approach.
One way to avoid a 401(k) or IRA withdrawal penalty is simply to leave the money untouched until you’re 59 1/2. It can be helpful to build a cash emergency fund that you can draw from if needed.
But if you still find that you need money from your retirement account before you reach age 59 1/2, there are some exceptions to the penalty rule. With workplace plans like 401(k)s, people who are at least 55 and quit their jobs—whether or not they’re starting new jobs—can spend 401(k) money and avoid the 10% withdrawal penalty. But to qualify, you have to be at least 55 before ending your employment. Plus, you may still owe income taxes on your withdrawal, so plan accordingly. Note: This exception does not apply to IRAs.
If you’re still working, some 401(k)s allow “in-service” withdrawals, but the 10% penalty applies up until age 59 1/2.
Another way to tap into your 401(k) is to take a plan loan. If you take a loan from your 401(k), you need to start repaying that loan at least quarterly (plus interest) to avoid the 401(k) withdrawal penalty, according to Russell. You’ll pay your own account back with interest. Many workplaces automatically deduct loan repayments from paychecks to help folks avoid that 10% premature penalty, Russell added. Employees who leave their companies while an outstanding 401(k) loan is due need to repay the loans in full if they are under 59 1/2. Otherwise, they’re subject to the penalty plus any taxes owed on the money not repaid. Note: IRAs do not allow investors to take loans.
Small business owners who have their own plans—such as a solo 401(k) or a profit-sharing plan—and take loans must also pay those back. It’s particularly important that small business owners pay back loans, because not only are they subject to the 10% penalty, “but their whole plan could become disqualified, which means all their plan assets, not just the loan, are subject to taxation,” Russell explained.
The key to filing taxes is being prepared. TD Ameritrade provides information and resources to help you navigate tax season.
For IRA plans, there are some additional exceptions to the 10% premature penalty, including certain higher education expenses and first-time home purchases. Both 401(k) and IRA distributions avoid the 10% penalty if the account owner meets the disability exceptionbut be careful. Proof of disability goes beyond obtaining Social Security disability payments. Other retirement account penalty exceptions also exist.
To report an early withdrawal, look for the tax forms from account custodians. The withdrawal will be reported on a 1099-R tax form, which goes out by the end of January for the previous tax year. The form will have codes that flag it as a premature distribution. Individuals should enter the information on their tax forms and file Form 5329 to report the penalty.
Did you accidentally put a little too much in your retirement account? That’s called an excess contribution, and the penalty is 6%. But the good news is you can correct an excess contribution without facing tax penalties.
Contact your IRA custodian with the amount of the excess contribution you made. Filers have until the extension filing date to correct an IRA excess—usually October 15. However, Russell said, “you also need to take out the earnings on that excess contribution.” Custodians can usually calculate that for you. You’ll owe a 10% premature distribution penalty on the earnings if you’re younger than 59 1/2. If you don’t correct the excess, the 6% penalty applies each year you miss the deadline until it’s fixed.
Tax Day is the deadline to correct a 401(k) excess. The 401(k) limit for 2023 is $22,500 for those younger than 50. It’s possible to contribute to multiple 401(k)s if you switch jobs or work two jobs; if you contribute more than $22,500 in a year, it’s called an excess deferral. Contact your 401(k) service provider or your HR department to let them know and get assistance correcting the excess deferral. Any earnings will be taxed but not subject to the 10% premature penalty. Note that all deferral plans are included in the $22,500 limit, including the SIMPLE IRA, individual or solo 401(k), and SARSEP (a specific SEP-IRA).
If you don’t correct your 401(k) excess deferral by Tax Day (usually April 15), the excess deferral will be subject to double taxation, both in the year contributed and the year it’s finally withdrawn. It will also be subject to the 10% premature penalty if you’re younger than 59 1/2. The earnings on the excess deferral are taxable in the year withdrawn.
Given the tax advantages of IRAs and 401(k)s, it’s no surprise that some people delay making withdrawals from their accounts for as long as possible. According to the SECURE 2.0 Act, passed in December 2022, retirees must begin taking their RMDs at the age of 73. Those still working who have an employer-sponsored work plan like a 401(k) may be able to delay RMDs until they actually stop working. (That exception doesn’t apply to business owners.)
Traditional IRA owners also still need to start taking RMDs at 73 regardless of work status to avoid an IRA withdrawal penalty. After turning 73, they can put off taking their initial RMD until the following April, but they’ll still need to take funds for the current year. For example, people who turn 73 in 2023 can delay the first RMD until April 1, 2024. But they also need to take a second RMD by December 31, 2024, “By waiting, people end up doubling up. So that could double up your tax bite as well and put you into a higher tax bracket. The year you turn 73, you might want to seriously consider not waiting until April,” Russell said.
Starting in 2023, if you fail to take an RMD, the IRS may impose an additional penalty tax of up to 25% on your missed RMD amount (the tax for missed RMDs before 2023 was 50%). For example, if your 2023 RMD was $10,000 and you miss the deadline to take it, the IRS may require you to pay a penalty tax of up to $2,500. For more detailed information on tax implications, please consult a tax advisor.
TD Ameritrade does not provide legal or tax advice. Please consult your legal or tax professional about your specific circumstance.
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