Premature Distribution

What Is a Premature Distribution?

A premature distribution (also known as an early withdrawal) is any distribution taken from an individual retirement account (IRA), 401(k) investment account, a tax-deferred annuity, or another qualified retirement-savings plan that is paid to a beneficiary who is younger than 59½ years old. Premature distributions are subject to a 10% early withdrawal penalty by the Internal Revenue Service (IRS) as a means of discouraging savers from spending their retirement assets prematurely.

How Premature Distributions Works

There are several instances in which the premature distribution penalty rules are waived, such as for first-time homebuyers, education expenses, medical expenses, and Rule 72(t), which states that a taxpayer can take IRA withdrawals before they are 59½ as long as they take at least five substantially equal periodic payments (SEPPs).

Early withdrawal applies to tax-deferred investment accounts. Two major examples of this are the traditional IRA and 401(k). In a traditional individual retirement account (IRA), individuals direct pretax income toward investments that can grow tax-deferred; no capital gains or dividend income is taxed until it is withdrawn. While employers can sponsor IRAs, individuals can also set these up individually.

In an employer-sponsored 401(k), eligible employees may make salary-deferral contributions on a post-tax and/or pretax basis. Employers have the chance to make matching or non-elective contributions to the plan on behalf of eligible employees and may also add a profit-sharing feature. As with an IRA, earnings in a 401(k) accrue tax-deferred.

Premature Distributions and the Taxpayer Relief Act

In 1997, Congress passed the Taxpayer Relief Act, which among other things, enabled taxpayers to withdraw up to $10,000 from tax-sheltered retirement accounts if that money is used to purchase a home for the first time.

American policymakers were eager in the 1990s to enact policies that promoted homeownership because they saw homeownership as the best means for promoting wealth accumulation. The bursting of the real estate bubble — and the trillions of dollars in savings lost as a result — has called into question the wisdom of these policies, but many such tax incentives for homeownership remain in the tax code.

Premature Distributions for Education and Medical Expenses

Students can also withdraw funds early from their qualified retirement accounts if they use the proceeds for qualified higher education expenses. Qualified expenses include tuition, supplies, or books needed to attend an accredited institution of higher learning. Taxpayers cannot use funds withdrawn early for living expenses, but they can use those funds for medical expenses. You can see a list of medical expenses approved by the IRS in publication 502. 

Alternative Strategies to Avoid Fees for Premature Distributions

Rule 72(t) is another popular strategy for avoiding IRS-levied, early withdrawal fees. Rule 72(t) refers to the section of the tax code that exempts taxpayers from such fees if they receive those payments in Substantially Equal Periodic Payments. This means you must withdraw your funds in at least five installments over five years, making this strategy less than ideal for those who need all their savings right away.

Congress has written in these exceptions in the tax code to support taxpayer behavior, which it sees as in the public interest. While U.S. policymakers see promoting retirement savings as one of their top priorities, they have made exceptions in the cases of new homeowners or those overburdened with expenses related to schooling and medical care.

To summarize, if the withdrawal meets one of the following stipulations it could be exempt from the penalty:

The RMD age was previously 70½ but was raised to 72 following the December 2019 passage of the Setting Every Community Up For Retirement Enhancement (SECURE) Act.

Special Considerations

In contrast with early withdrawal penalties on premature distributions, a retirement saver can also be penalized later on if mandatory withdrawals are not started by a certain point. For example, in a traditional, SEP, or SIMPLE IRA qualified plan, participants must begin withdrawing by April 1 following the year they reach age 72. Each year the retiree must withdraw a specified amount based on the currently required minimum distribution (RMD) calculation. This is generally determined by dividing the retirement account's prior year-end fair market value by life expectancy.