10% Withholding Vs. 10% "Penalty"
There is a Big Difference
The 10% assessment on premature retirement distributions is actually an additional tax rather than a penalty. Both individual
retirement account (IRA) owners and IRA administrators are often confused about the federal income tax withholding
and the additional tax because of the "10 percent" similarity.
The 10% withholding is a federal income tax withholding requirement that can be waived by an IRA owner when they take
a distribution. The amount withheld is actually a prepayment on the account holder's federal income tax liability for
the year. An individual must make an election as to the amount to be withheld. If no election is made by the IRA owner,
the bank is required to withhold 10% of the total distribution for federal income tax purposes. An individual makes
this withholding election by completing IRS form W-4P, Withholding Certificate, or a suitable substitute.
Unlike the federal income tax withholding, the additional 10% premature distribution tax is an IRA owner's responsibility
and applies to traditional, Roth, Simplified Employee Pension (SEP) programs, and Savings Incentive Match Plan for Employees of
Small Employers (SIMPLE) IRAs as well as Coverdell Education Savings Accounts. Generally this distribution applies to an
individual who takes distributions of funds prior to age 59 1/2 and does not meet an exception to the additional tax.
Exceptions to the 10% premature distribution tax include:
- distributions for first-time
homebuyers;
- certain higher education
expenses;
- health insurance premiums
and medical expenses;
- substantially equal
periodic payments;
- IRS levies; and
- conversions, disability
and death distributions.
An IRA owner and their tax advisor must determine whether this penalty (additional tax) applies. If the tax does
indeed apply, the IRA owner will either report the additional tax directly on his/her federal tax return or on
IRS Form 5239.
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