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How Saving for Retirement Affects Your Tax Return

It’s never too early -- or too late -- to start thinking about retirement planning. But in order to maximize your tax benefits and avoid tax implications, it’s important to follow a few rules.

Photo: Thinkstock / The Nest

It’s very important to have a retirement plan, such as an IRA or 401(k). But bear in mind, these plans carry tax penalties if you don't follow the plan rules. Primarily, you may have to pay a penalty for withdrawing money early (that is, before you retire or reach a certain age). Here’s how the penalty works and how you can possibly avoid it.

Exceptions to Early-Distribution Penalties

Contributions to a tax-deferred savings plan are subject to a 10 percent early-withdrawal penalty. You're normally subject to the penalty if you withdraw money from your retirement plan before age 59 and a half. But exceptions to the 10 percent penalty do exist.

The early-withdrawal penalty doesn't typically apply to distributions from your employer retirement plan or IRA if:

  • The distribution is due to total and permanent disability
  • Your beneficiary receives the distribution from your retirement plan after your death
  • You receive distributions as a series of substantially equal periodic payments based upon your life expectancy -- or the joint life expectancies of you and your designated beneficiary (if from an employer plan, the distributions must begin after your separation from service)
  • You receive the distribution after separation from employment during or after the year you reach age 55 -- or 50 for qualified safety employees. But this exception doesn't apply to IRAs.
  • You use the distribution to pay medical expenses that are more than 7.5 percent of your adjusted gross income (AGI)
  • You received the distribution as a reservist or National Guard member if on active duty for at least 180 days
  • A federal tax levy forces your qualified plan or IRA to make a distribution

Getting Your Money Early

There's a way to receive distributions from your traditional IRA without paying the 10 percent early-withdrawal penalty -- even if you receive the distributions before age 59 and a half. This is known as the equal periodic payment exception.

To receive the distributions under this exception without a penalty, all of these must apply:

  • The distributions must be part of a series of substantially equal payments based upon your life expectancy and the joint life expectancies of you and your designated beneficiary
  • You must use an IRS-approved distribution method
  • You must take at least one distribution annually
  • You must receive the distributions for at least five years and until you're at least 59 and a half

Although this installment method saves you the 10 percent early-withdrawal penalty, you'll still have to pay tax on amounts not considered a return of your nondeductible contributions.

If you haven't yet received payments for at least five years, you might have to pay an early distribution recapture tax even if you modify your method of distribution after reaching age 59 and a half. In that case, the tax applies only to payments distributed before you reached 59 and a half.

Ready to do your taxes? Head over to H&R Block and sign up to get a 20% discount on their tax services -- just for Nesties!