Taxpayer-Friendly Changes to Retirement Plan Penalties
Good to Know
Distributions from Traditional IRAs and employer-sponsored retirement plans such as 401(k) plans are generally subject to a penalty for taking the money out too early (premature distribution) or too late (delayed distribution penalty). Secure Act 2.0 gives welcome penalty relief effective for tax years beginning on or after January 1, 2023.
Terminal Illness Exception
The premature distribution penalty on taxable distributions taken before age 59½ is generally subject to a 10% penalty. The penalty is assessed on the taxable amount of the distributions. The Terminal Illness Exception is a long overdue addition to the existing exceptions.
Here’s how it works—effective for tax years beginning on or after January 1, 2023—a taxpayer with a medically certified illness expected to result in death within 84 months may take premature distributions from their Traditional IRA or qualified plan without penalty. Take careful note of the word “expected” in this new exception. The strong implication is that the mere expectation satisfies the exception requirement, even if the taxpayer lives longer than 84 months.
Caveat, any taxable distributions must still be included in the taxpayer’s total gross income—this new exception is for the penalty only.
Under Distribution and Delayed Distribution Penalty Exceptions
Historically, taking distributions too late (after a taxpayer’s required beginning date) or taking too little (failing to take the full required minimum distribution) resulted in a confiscatory penalty of 50%. For example, assume a taxpayer had a taxable required minimum distribution of $50,000 in 2022 but only took a distribution of $30,000. The under-distribution would have been $20,000 and the resulting under-distribution penalty would have been $10,000.
But what would have happened if the $20,000 under-distribution occurred in 2023 instead of 2022? Effective for tax years beginning on or after January 1, 2023, the penalty is reduced to 25%. Thus, the taxpayer in the example above would have paid $5,000 less in penalty.
Traditional IRA Corrective Distribution Penalty
There are two penalties in play here: the 6% over-contribution penalty and the 10% premature distribution penalty. The over-contribution penalty has not changed and we’ll summarize it for you now.
Assume your client contributed $6,500 to their Traditional IRA but only had $5,000 in earned income for the year, resulting in a $1,500 over-contribution. The excess contribution penalty of 6% is waived if the taxpayer made a corrective distribution of $1,500 before the due date—including extensions—of the income tax return.
In years ending before 12/31/2022, a 10% premature distribution penalty would have been assessed against any gains or income from the over-contribution. Effective for years beginning on or after January 1, 2023, an exception applies to these gains or income so that no 10% penalty would be assessed. This assumes that a timely corrective distribution is made.
The Bottom Line
Secure Act 2.0 brought much-needed penalty relief for taxable distributions from Traditional IRAs and employer-sponsored retirement plans. This blog contains only those provisions effective for 2023. Other provisions of the ACT will be phased in from 2024 through 2026 and we’ll report those as they become effective.
The information presented herein is provided purely for educational purposes and to raise awareness of these issues; it is not meant to provide and should not be used to provide legal, identity theft protection, investment, income tax, risk management, retirement, estate, or financial planning advice of any kind. An experienced and credentialed expert should be consulted before making decisions relating to the topics covered herein. There are variations, alternatives, and exceptions to this material that could not be covered within the scope of this blog.