Typically, early withdrawal penalties for tax-deferred retirement accounts such as IRAs and 403(b) plans incurring 10% penalties apply when withdrawing distributions before age 59 12, except when an exception applies. Under the 2022 Secure Act however, additional exceptions have been added in order to help account holders meet unexpected financial needs without jeopardizing long-term savings goals.
Some exceptions for service termination could include total and permanent disability, unreimbursed medical expenses, separation at age 55+ etc.
Tax-free distributions for COVID-related distributions
If a participant receives a COVID distribution from their employer’s retirement plan and then later contributes it back within three years, their federal personal income tax liability should generally be exempted.
Note, however, that withdrawals made due to COVID are eligible for this waiver; specifically this exemption (expanded under SECURE 2.0) only covers coronavirus-related withdrawals from eligible employer plans and IRAs.
Other early withdrawals resulting from disaster or separation from service are subject to the 10% early withdrawal penalty, however. COVID withdrawals differ for state income tax purposes: Vermont law treats them like rollovers and includes them in gross income three years post distribution year as well as any portion repaid within this three year window; unlike with federal rules, however, there is no maximum limit for repayment during this three year window.
Disaster-related distributions
Under a newly instituted rule, individuals who suffered economic loss due to a federally declared disaster after 2021 can withdraw up to $22,000 from their employer-sponsored retirement plans (such as section 401(k), 403(b) plans or IRAs without needing to meet normal distribution requirements or incur the 10% penalty penalty. They also can spread these withdrawals over three years for maximum tax efficiency.
The Internal Revenue Service offers special rules and worksheets to aid taxpayers in reporting qualified disaster recovery distributions. A new Form 8915 was recently created to aid individuals in reporting these distributions or repayments on their tax returns.
The IRS now expects all plans to allow individuals to repay any part of their qualified disaster recovery distributions within three years and considers such repayments trustee-to-trustee rollovers, unlike prior guidance which treated such repayments as ordinary income. Likewise, they allow people to delay repaying plan loans up to one year post receipt.
Separation from service at age 55 or older
As the COVID-19 pandemic progresses, many workers may reassess their career plans. This could include early retirement which can incur IRS penalties on distributions from employer-sponsored 401(k) and 403(b).
Good news for those retiring on or after their 55th birthday: they can access their workplace retirement plans without incurring the 10% early withdrawal penalty. The “rule of 55” applies to withdrawals from any employer-sponsored defined contribution plan – including 401(k)s and 403(b).
To qualify for this exception, your separation from service must occur in the year that you turn 55 or older and your withdrawals must come from the plan from which you separated from service. To take advantage of this exception and complete these withdrawals properly, complete an ET-7355 Authorization for Direct Rollover form before withdrawing from service; additionally, obtain a letter from your physician verifying eligibility to receive such distributions.
Terminally ill distributions
SECURE 2.0 now also accommodates disaster, COVID and separation from service exceptions as well as terminally ill individuals in its list of exceptions from early withdrawal penalties, along with total and permanent disability and unreimbursed medical expenses exceeding 7.5% of adjusted gross income.
Participants claiming terminal illness as their reason for receiving a distribution must present a physician’s certification confirming they have an impairment that will likely cause death within seven years, and must not have been the source of hardship distribution or leave of absence from employment in the year prior to receiving their distribution.
The SECURE 2.0 Act of 2022 builds on Congress’ desire to give retirement plan participants greater access to their savings. It allows plans to provide penalty-free distributions in cases such as natural disasters, domestic abuse or unexpected personal expenses; or where premiums for certified long-term care insurance have become due.
