Special Additional Taxes

To discourage the use of pension funds for purposes other than normal retirement, the law imposes additional taxes on certain distributions of those funds and on failures to withdraw the funds timely. Ordinarily, you will not be subject to these taxes if you roll over all early distributions you receive, as explained earlier, and begin drawing out the funds at a normal retirement age, in reasonable amounts over your life expectancy. These special additional taxes are the taxes on:

• Early distributions, and
• Excess accumulation (not receiving minimum distributions).

These taxes are discussed in the following sections.

If you must pay either of these taxes, report them on Form 5329, Additional Taxes Attributable to IRAs, Other Qualified Retirement Plans, Annuities, Modified Endowment Contracts, and MSAs. However, you do not have to file Form 5329 if you owe only the tax on early distributions and your Form 1099-R shows a "1" in box 7. Instead, enter 10% of the taxable part of the distribution on line 54 of Form 1040 and write "No" on the dotted line next to line 54.

Even if you do not owe any of these taxes, you may have to complete Form 5329 and attach it to your Form 1040. This applies if you received an early distribution and your Form 1099-R does not show distribution code "2,""3," or "4" in box 7 (or the code number shown is incorrect).

Tax on Early Distributions

Most distributions (both periodic and nonperiodic) from qualified retirement plans and deferred annuity contracts made to you before you reach age 59 1/2 are subject to an additional tax of 10%. This tax applies to the part of the distribution that you must include in gross income. It does not apply to any part of a distribution that is tax free, such as amounts that represent a return of your cost or that were rolled over to another retirement plan. It also does not apply to corrective distributions of excess deferrals, excess contributions, or excess aggregate contributions (discussed earlier at the beginning of Taxation of Nonperiodic Payments).

For this purpose, a qualified retirement plan is:

1. A qualified employee plan (including a qualified cash or deferred arrangement (CODA) under Internal Revenue Code section 401(k)),
2. A qualified employee annuity plan,
3. A tax-sheltered annuity plan for employees of public schools or tax-exempt organizations, or
4. An IRA (other than an education (Ed) IRA).

25% rate on certain early distributions from SIMPLE IRA plans. An early distribution from a SIMPLE IRA is generally subject to the 10% additional tax. However, if the distribution is made within the first two years of participation in the SIMPLE plan, the additional tax is 25%. Your Form 1099-R should show distribution code "S" in box 7 if the 25% rate applies. On line 4 of Form 5329, multiply by 25% instead of 10%.

5% rate on certain early distributions from deferred annuity contracts. If an early withdrawal from a deferred annuity is otherwise subject to the 10% additional tax, a 5% rate may apply instead. A 5% rate applies to distributions under a written election providing a specific schedule for the distribution of your interest in the contract if, as of March 1, 1986, you had begun receiving payments under the election. On line 4 of Form 5329, multiply by 5% instead of 10%. Attach an explanation to your return.

Exceptions to tax. Certain early distributions are excepted from the early distribution tax. If the payer knows that an exception applies to your early distribution, distribution code "2,""3," or "4" should be shown in box 7 of your Form 1099-R and you do not have to report the distribution on Form 5329. If an exception applies but distribution code "1" (early distribution, no known exception) is shown in box 7, you must file Form 5329. Enter the taxable amount of the distribution shown in box 2a of your Form 1099-R on line 1 of Form 5329. On line 2, enter the amount that can be excluded and the exception number shown in the Form 5329 instructions.

If distribution code "1" is incorrectly shown on your Form 1099-R for a distribution received when you were age 59 1/2 or older, include that distribution on Form 5329. Enter exception number "11" on line 2.

The early distribution tax does not apply to any distribution that meets one of the following exceptions.

General exceptions. The tax does not apply to distributions that are:

• Made as part of a series of substantially equal periodic payments (made at least annually) for your life (or life expectancy) or the joint lives (or joint life expectancies) of you and your beneficiary (but, if from a qualified retirement plan other than an IRA, only if the payments begin after your separation from service),
• Made because you are totally and permanently disabled, or
• Made on or after the death of the plan participant or contract holder.

Additional exceptions for qualified retirement plans. The tax does not apply to distributions that are:

• From a qualified retirement plan (other than an IRA) after your separation from service in or after the year you reached age 55,
• From a qualified retirement plan (other than an IRA) to an alternate payee under a qualified domestic relations order,
• From a qualified retirement plan to the extent you have deductible medical expenses (medical expenses that exceed 7.5% of your adjusted gross income), whether or not you itemize your deductions for the year,
• From an employer plan under a written election that provides a specific schedule for distribution of your entire interest if, as of March 1, 1986, you had separated from service and had begun receiving payments under the election,
• From an employee stock ownership plan for dividends on employer securities held by the plan, or
• From a qualified retirement plan due to an IRS levy of the plan.

Additional exceptions for IRAs. The tax does not apply to distributions that are:

• From an IRA for medical insurance premiums if you are unemployed,
• From an IRA to the extent of your higher education expenses, or
• From an IRA for first home purchases.

For detailed information about the exceptions that apply only to IRAs, see When Can I Withdraw or Use IRA Assets in chapter 1 of Publication 590.

Additional exceptions for nonqualified annuity contracts. The tax does not apply to distributions that are:

• From a deferred annuity contract to the extent allocable to investment in the contract before August 14, 1982,
• From a deferred annuity contract under a qualified personal injury settlement,
• From a deferred annuity contract purchased by your employer upon termination of a qualified employee plan or qualified annuity plan and held by your employer until your separation from service, or
• From an immediate annuity contract (a single premium contract providing substantially equal annuity payments that start within one year from the date of purchase and are paid at least annually).

Recapture tax for changes in distribution method under equal payment exception. An early distribution recapture tax may apply if, before you reach age 59 1/2, the distribution method under the equal periodic payment exception changes (for reasons other than your death or disability). The tax applies if the method changes from the method requiring equal payments to a method that would not have qualified for the exception to the tax. The recapture tax applies to the first tax year to which the change applies. The amount of tax is the amount that would have been imposed had the exception not applied, plus interest for the deferral period.

The recapture tax also applies if you do not receive the payments for at least 5 years under a method that qualifies for the exception. It applies even if you modify your method of distribution after you reach age 59 1/2. In that case, the tax applies only to payments distributed before you reach age 59 1/2.

Tax on Excess Accumulation

To make sure that most of your retirement benefits are paid to you during your lifetime, rather than to your beneficiaries after your death, the payments that you receive from qualified retirement plans must begin no later than your required beginning date (defined later). The payments each year cannot be less than the minimum required distribution.

If the actual distributions to you in any year are less than the minimum required distribution for that year, you are subject to an additional tax. The tax equals 50% of the part of the required minimum distribution that was not distributed.

The additional tax applies to qualified employee plans, qualified employee annuity plans, section 457 deferred compensation plans, tax-sheltered annuity plans (for benefits accruing after 1986), and IRAs (other than education (Ed) IRAs and Roth IRAs).

Waiver. The tax may be waived if you establish that the shortfall in distributions was due to reasonable error and that reasonable steps are being taken to remedy the shortfall. If you believe you qualify for this relief, you must file Form 5329, pay the tax, and attach a letter of explanation. If the IRS grants your request, the tax will be refunded.

State insurer delinquency proceedings. You might not receive the minimum distribution because of state insurer delinquency proceedings for an insurance company. If your payments are reduced below the minimum because of these proceedings, you should contact your plan administrator. Under certain conditions, you will not have to pay the excise tax.

Required beginning date. Unless the rule for 5% owners and IRAs applies, you must begin to receive distributions from your qualified retirement plan by April 1 of the year that follows the later of:

1. The calendar year in which you reach age 70 1/2, or
2. The calendar year in which you retire.

5% owners and IRAs. If you are a 5% owner of the employer maintaining your qualified retirement plan, or if your qualified retirement plan is an IRA, you must begin to receive distributions from the plan by April 1 of the year that follows the calendar year in which you reach age 70 1/2. This rule does not apply if your retirement plan is a government or church plan.

You are a 5% owner if, for the plan year ending in the calendar year in which you reach age 70 1/2, you own (or are considered to own under section 318 of the Internal Revenue Code) more than 5% of the outstanding stock (or more than 5% of the total voting power of all stock) of the employer, or more than 5% of the capital or profits interest in the employer.

Age 70 1/2. You reach age 70 1/2 on the date that is 6 calendar months after the date of your 70th birthday. For example, if your 70th birthday was on June 30, 1999, you reached age 70 1/2 on December 30, 1999. If your 70th birthday was on July 1, 1999, you reached age 70 1/2 on January 1, 2000.

Required distributions. By the required beginning date, as explained above, you must either:

1. Receive your entire interest in the plan (for a tax-sheltered annuity, your entire benefit accruing after 1986), or
2. Begin receiving periodic distributions in annual amounts calculated to distribute your entire interest (for a tax-sheltered annuity, your entire benefit accruing after 1986) over your life or life expectancy or over the joint lives or joint life expectancies of you and your designated beneficiary (or over a shorter period).

The term "designated beneficiary" as used in (2) above means the individual who is your beneficiary under your retirement plan or annuity upon your death. If you have more than one beneficiary, the beneficiary with the shortest life expectancy, usually the oldest individual, will be the "designated beneficiary."

After the starting year for periodic distributions, you must receive the minimum required distribution for each year by December 31 of that year. (The starting year is the year in which you reach age 70 1/2 or retire, whichever applies in determining your required beginning date.) If no distribution is made in your starting year, the minimum required distributions for 2 years must be made the following year (one by April 1 and one by December 31).

Example. You retired under a qualified employee plan in 1999. You are not a 5% owner. You reached age 70 1/2 on August 20, 2000. For 2000 (your starting year), you must receive a minimum amount from your retirement plan by April 1, 2001. You must receive the minimum required distribution for 2001 by December 31, 2001.

Distributions after the employee's death. If the employee was receiving periodic distributions before his or her death, any payments not made as of the time of death must be distributed at least as rapidly as under the distribution method being used at the date of death.

If the employee dies before the required beginning date, the entire account must be distributed under one of the following rules.

• Rule 1. The distribution must be completed by December 31 of the fifth year following the year of the employee's death.
• Rule 2. The distribution must be made in annual amounts over the life or life expectancy of the designated beneficiary.

The terms of the plan determine which of these two rules applies. If the plan permits the employee or the beneficiary to choose the rule that applies, this choice must be made by the earliest date a distribution would be required under either of the rules. Generally, this date is December 31 of the year following the year of the employee's death.

If the employee or the beneficiary did not choose either rule and the plan does not specify the one that applies, distribution must be made under rule 2 if the beneficiary is the surviving spouse and under rule 1 if the beneficiary is someone other than the surviving spouse.

Distributions under rule 2 generally must begin by December 31 of the year following the year of the employee's death. However, if the surviving spouse is the beneficiary, distributions need not begin until December 31 of the year the employee would have reached age 70 1/2, if later.

If the surviving spouse is the designated beneficiary and distributions are to be made under rule 2, a special rule applies if the spouse dies after the employee but before distributions are required to begin. In this case, distributions may be made to the spouse's beneficiary under either rule 1 or rule 2, as though the beneficiary were the employee's beneficiary and the employee died on the spouse's date of death. However, if the surviving spouse remarries after the employee's death and the new spouse is designated as the spouse's beneficiary, this special rule applicable to surviving spouses does not apply to the new spouse.

Minimum distributions from annuity plan. Special rules apply if you receive distributions from your retirement plan in the form of an annuity. Your plan administrator should be able to give you information about these rules.

Minimum distributions from an individual account plan. If there is an account balance to be distributed from your plan (not as an annuity), your plan administrator must figure the minimum amount that must be distributed from the plan each year. For distributions being made over life expectancy, this amount is figured by dividing the account balance at the end of the preceding year by an applicable life expectancy (from tables published in Publication 939). The applicable life expectancy is:

1. The life expectancy of the employee, or the joint life and last survivor expectancy of the employee and the designated beneficiary, if distributions begin by the employee's required beginning date, or
2. The life expectancy of the designated beneficiary if the employee dies before the required beginning date.

Account balance. This is the value of the account balance at the end of the preceding year (valuation calendar year), adjusted as follows.

1. Add the amount of any contributions made for the valuation calendar year, including those made after the close of the valuation date (up to the filing due date (plus extensions) of the individual income tax return of the plan participant).
2. Subtract distributions made in the valuation calendar year after the valuation date.

What types of installments are allowed? The minimum amount that must be distributed for any year may be made in a series of installments (e.g., monthly, quarterly, etc.) as long as the total payments for the year made by the date required are not less than the minimum amount required.

More than minimum. Your plan can distribute more in any year than the minimum amount required for that year but, if it does, you will not receive credit for the additional amount in determining the minimum amount required for future years. However, any amount distributed in your starting year will be credited toward the amount required to be distributed by April 1 of the following year.

Life expectancy. For distributions beginning during your life that are made by April 1 after your starting year, the initial life expectancy (or joint life and last survivor expectancy) is determined using the ages of you and your designated beneficiary as of your birthdays in your starting year.

For distributions beginning after the employee's death (if death occurred before April 1 following the employee's starting year) over the life expectancy of the designated beneficiary, the initial life expectancy of the designated beneficiary is determined using the beneficiary's age as of his or her birthday in the year distributions must begin.

Unless your plan provides otherwise, your life expectancy (and that of your spouse, if it applies) must be redetermined annually. (The life expectancy of a designated beneficiary who is someone other than your spouse cannot be redetermined.) If life expectancy is not redetermined, the initial life expectancy is simply reduced by one for each year after your starting year to determine the remaining life expectancy.

If the life expectancies of both the employee and the employee's spouse are redetermined, and either one dies, use only the survivor's life expectancy to figure distributions in years following the year of death. If both the employee and his or her spouse die, the entire remaining interest must be distributed by the end of the year following the year of the second death.

If the life expectancy of only one individual (either the employee or the employee's spouse) is redetermined and that individual dies, use only the other individual's life expectancy to figure distributions in years following the year of death. If, instead, the other individual dies, his or her life expectancy as if the death had not occurred continues to be used to figure the remaining distributions. These rules also apply if the designated beneficiary is someone other than the employee's spouse.

Your plan may also permit you and your spouse to choose whether or not your life expectancies are to be redetermined. This choice must be made by the date the first distribution is required to be made from the plan.

Minimum distribution incidental benefit requirement. Distributions from a retirement plan during the employee's lifetime must satisfy, in addition to the above requirements, the minimum distribution incidental benefit (MDIB) requirement. This requirement is to ensure that the plan is used primarily to provide retirement benefits to the employee. After the employee's death, only "incidental" benefits are expected to remain for distribution to the employee's beneficiary (or beneficiaries).

If your spouse is your only beneficiary, the MDIB requirement is satisfied if the general minimum distribution requirements discussed above are satisfied. If your spouse is not your only beneficiary, your plan administrator must figure your required minimum distribution by dividing the account balance at the end of the year by the smaller of the applicable life expectancy or the MDIB divisor that applies (from a table published in Publication 939).

Combining multiple accounts to satisfy the minimum distribution requirements. Generally, the required minimum distribution must be figured separately for each account. Each qualified employee retirement plan and qualified annuity plan must be considered individually in satisfying its distribution requirements. However, if you have more than one tax-sheltered annuity account or more than one individual retirement arrangement (IRA), you can total the required distributions and then satisfy the requirement by taking distributions from any one (or more) of the tax-sheltered annuities or IRAs, respectively. Distributions from tax-sheltered annuities will not satisfy the distribution requirements for IRAs, nor will distributions from IRAs satisfy the requirements for tax-sheltered annuity distributions.

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