In the interest of encouraging workers to save for retirement, Congress has authorized several kinds of retirement savings plans that qualify for reduced or deferred income taxes. These plans provide a financial incentive for people to save, either by allowing workers and employers to deduct from income the amount they contribute to the plan or to take tax-free distributions from the plan after they retire. This CRS Report summarizes the provisions of law that govern the taxes applicable to pre-retirement distributions from retirement accounts, and the situations in which distributions must be taken from a plan in order to avoid a tax penalty.
Because tax-deductible contributions to retirement plans and deferral of taxes on investment earnings reduce federal income tax collections, Congress has placed limits on the amount that can be contributed to these plans each year. To assure that the tax preferences granted to retirement accounts are used to promote retirement income security rather than to subsidize transfers of wealth from one generation to the next, federal law requires owners of retirement accounts that are funded with taxdeductible contributions to begin taking required minimum distributions from the accounts after they reach age 70½. Failure to take a required minimum distribution will result in a tax penalty equal to 50% of the amount that should have been distributed. Retirement plans that are funded with after-tax income — like the “Roth IRA” — do not have required minimum distributions during the account owner’s lifetime.
To discourage individuals from taking pre-retirement withdrawals from retirement savings accounts, the Internal Revenue Code (I.R.C.) imposes a 10% penalty on withdrawals taken before age 59½, which is levied in addition to any other applicable income tax. Recognizing that some significant events might require people to withdraw money from their retirement accounts earlier than expected, Congress has provided in law for waiving the 10% early withdrawal penalty in some situations. As with required distributions after age 70½, Roth IRAs have a special rule with respect to early withdrawals. Because contributions to a Roth IRA must consist entirely of income on which income tax has already been paid, qualified distributions from a Roth IRA are not subject to income taxes or penalties.