Designated Roth accounts. For tax years beginning after 2005, a 401(k) or 403(b) plan can include a qualified Roth contribution program. Under that program, designated Roth contributions are treated as elective deferrals, except that the contributions are included in income. See Designated Roth accounts, later, for more information.

Qualified reservist distributions. The additional 10% tax on early distributions does not apply to a qualified reservist distribution. See Qualified reservist distributions later, for more information.

Public safety employees. After August 17, 2006, the additional 10% tax on early distributions does not apply to distributions from qualified governmental plans, if you were a public safety employee who separated from service after you reached age 50. See Publication 575 for more information.

Rollovers by nonspouse beneficiary. For distributions after 2006, a nonspouse designated beneficiary may have a distribution from an eligible retirement plan of a deceased employee directly transferred (trustee-to-trustee) to his or her own IRA set up to receive the distribution. The transfer will be treated as an eligible rollover distribution and the receiving plan will be treated as an inherited IRA. See Rollovers by nonspouse beneficiary later, for more information.

Retired public safety officers. For distributions after 2006, an eligible retired public safety officer can elect to exclude from income distributions of up to $3,000 made directly from a governmental retirement plan to the providers of accident, health, or long-term care insurance. See Publication 575 for more information.

Hurricane tax relief. Special rules apply to the use of retirement funds by qualified individuals who suffered an economic loss as a result of Hurricane Katrina, Rita, or Wilma. See Hurricane-Related Relief, in Publication 575, or Publication 4492, Information for Taxpayers Affected by Hurricanes Katrina, Rita, and Wilma, for information on these special rules.

This chapter discusses the tax treatment of distributions you receive from:

Before you can figure how much, if any, of a distribution from your pension or annuity plan is taxable, you must determine your cost (your investment in the contract) in the pension or annuity. Your total cost in the plan includes everything that you paid. It also includes amounts your employer paid that were taxable to you when paid. Cost does not include any amounts you deducted or excluded from income.

From this total cost, subtract any refunds of premiums, rebates, dividends, unrepaid loans, or other tax-free amounts you received by the later of the annuity starting date or the date on which you received your first payment.

Your annuity starting date is the later of the first day of the first period for which you received a payment, or the date the plan's obligations became fixed.

Nonperiodic distributions are also known as amounts not received as an annuity. They include all payments other than periodic payments and corrective distributions.

If you withdraw cash or other assets from a qualified retirement plan in an eligible rollover distribution, you can defer tax on the distribution by rolling it over to another qualified retirement plan or a traditional IRA.

For this purpose, the following plans are qualified retirement plans.

Withholding tax.   If you choose to have all or any part of the distribution paid to you, it is taxable in the year distributed unless you roll it over to another qualified plan or to a traditional IRA within 60 days. The plan administrator must withhold income tax of 20% from the amount of the distribution paid to you. (See Pensions and Annuities under Withholding in chapter 4.)

  

If you decide to roll over an amount equal to the distribution before withholding, your contribution to the new plan or IRA must include other money (for example, from savings or amounts borrowed) to replace the amount withheld.

  The administrator must give you a written explanation of your distribution options within a reasonable period of time before making an eligible rollover distribution.

To discourage the use of pension funds for purposes other than normal retirement, the law imposes additional taxes on early 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:

These taxes are discussed in the following sections.

If you must pay either of these taxes, report them on Form 5329. However, you do not have to file Form 5329 if you owe only the tax on early distributions and your Form 1099-R correctly shows a “1” in box 7. Instead, enter 10% of the taxable part of the distribution on Form 1040, line 60 and write “No” under the heading “Other Taxes” to the left of line 60.

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 meet an exception to the tax on early distributions but box 7 of your Form 1099-R does not indicate an exception.

Tax on Early Distributions

Most distributions (both periodic and nonperiodic) from qualified retirement plans and nonqualified annuity contracts made to you before you reach age 59½ are subject to an additional tax of 10%. This tax applies to the part of the distribution that you must include in gross income.

For this purpose, a qualified retirement plan is:

• A qualified employee plan,

• A qualified employee annuity plan,

• A tax-sheltered annuity plan, or

• An eligible state or local government section 457 deferred compensation plan (to the extent that any distribution is attributable to amounts the plan received in a direct transfer or rollover from one of the other plans listed here).

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 59½ or older, include that distribution on Form 5329. Enter exception number “12” on line 2.

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 designated beneficiary (if from a qualified retirement plan, the payments must 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 (age 50 for qualified public safety employees),

• 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,

• From a qualified retirement plan due to an IRS levy of the plan, or

• From elective deferral accounts under 401(k) or 403(b) plans or similar arrangements that are qualified reservist distributions.

Qualified reservist distributions.   A qualified reservist distribution is not subject to the additional tax on early distributions. A qualified reservist distribution is a distribution (a) from elective deferrals under a section 401(k) or 403(b) plan, (b) to an individual ordered or called to active duty (because he or she is a member of a reserve component) for a period of more than 179 days or for an indefinite period, and (c) made during the period beginning on the date of the order or call and ending at the close of the active duty period. You must be ordered or called to active duty after September 11, 2001, and before December 31, 2007. For more information, see Publication 575.

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 employee 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).

If you receive a survivor annuity because of the death of a retiree who had reported the annuity under the Three-Year Rule, include the total received in income.

If the retiree was reporting the annuity payments under the General Rule, you must apply the same exclusion percentage to your initial survivor annuity payment called for in the contract. The resulting tax-free amount will then remain fixed. Any increases in the survivor annuity are fully taxable.

If the retiree was reporting the annuity payments under the Simplified Method, the part of each payment that is tax free is the same as the tax-free amount figured by the retiree at the annuity starting date. See Simplified Method, earlier.

In any case, if the annuity starting date is after 1986, the total exclusion over the years cannot be more than the cost.

If you are the survivor of an employee, or former employee, who died before becoming entitled to any annuity payments, you must figure the taxable and tax-free parts of your annuity payments using the method that applies as if you were the employee.