Early Withdrawal Penalties in California Before 59½

The two layers

The federal additional tax on distributions taken before age 59½ is widely known. California's own additional tax, assessed separately, is less familiar.

California Revenue and Taxation Code section 17085 adopts the federal rules on early distributions but reduces the rate, setting the state additional tax at 2.5 percent rather than 10 percent. It is reported on Form FTB 3805P and described in the Franchise Tax Board's Publication 1005. For certain SIMPLE IRA distributions taken within the first two years of participation, the state rate is 6 percent rather than 2.5, and the federal rate is 25 percent rather than 10.

A general summary of current rules. Rates, brackets, and exceptions change. Confirm your own position with your CPA.

For most taxable retirement distributions taken before age 59½, the combined federal and California additional taxes generally total 12.5 percent, assuming no exception applies. Certain SIMPLE IRA distributions made within the first two years of participation may instead be subject to a combined 31 percent additional tax. These taxes are separate from ordinary income taxes.

California's Office of Tax Appeals has decided cases in which a taxpayer reported and paid the federal additional tax but omitted the state one, and the Franchise Tax Board assessed the difference plus interest after receiving federal data. Examples include the Appeals of Martinez (2019), Hughes (2018) and Yeh (2021), in which the assessments were upheld.

The exceptions

Both the federal and the California additional taxes have exceptions. California generally follows many federal exceptions to early-distribution taxes. However, certain federal provisions may receive different treatment under California law. Eligibility for an exception should be verified under both federal and California rules before taking a distribution, and reported correctly on Form FTB 3805P.

Commonly relied-on federal exceptions include the following. The precise conditions matter considerably, and several apply only to IRAs or only to employer plans.

• Death of the account owner, and total and permanent disability.
• A series of substantially equal periodic payments, covered below.
• Separation from service in or after the year you turn 55, for an employer plan only.
• Unreimbursed medical expenses above an applicable threshold.
• Health insurance premiums while receiving unemployment compensation, for IRAs.
• Qualified higher education expenses and a qualified first-time home purchase, for IRAs, with a lifetime limit on the latter.
• A levy by the IRS on the account.
• Qualified birth or adoption, qualified disaster recovery, and the newer provisions for terminal illness, domestic abuse victims, and emergency personal expenses.
• A return of basis, which is not taxable in the first place.

Two cautions. The exception has to be claimed on the return and documented; it does not apply automatically because the circumstances existed. And the fact that a custodian codes a distribution as early does not determine whether an exception applies, which is a question for your CPA.

The Rule of 55

This exception is useful and easy to lose by accident, which is why it gets its own section.

If you separate from service in or after the calendar year you turn 55, distributions from that employer's plan are generally not subject to the additional tax. Special rules, including a lower age, apply to certain public safety employees and firefighters. The Rule of 55 may provide an important opportunity for eligible individuals who separate from employment before age 59½ to access certain employer-sponsored retirement funds without the additional early-distribution tax. The plan's own provisions govern whether and how distributions are available.

The trap is that it applies to the employer plan, not to an IRA. One costly sequence runs like this: someone retires at 56, rolls the 401(k) into an IRA for more investment choice and simpler administration, and then discovers that distributions from the IRA are subject to the additional tax until 59½, where distributions from the plan would not have been.

The practical step is to consider the rollover timing and the distribution plan together rather than in sequence. Leaving some or all of the balance in the plan until 59½, and rolling the remainder afterward, is one approach. Whether it fits depends on the plan's distribution flexibility, its investment menu, and the rest of the income plan.

Substantially equal periodic payments

A series of substantially equal periodic payments, often called a 72(t) arrangement after the federal code section, allows distributions before 59½ without the additional tax, calculated under one of several approved methods.

It carries a hard condition. The series generally has to continue for at least five years or until age 59½, whichever is later. Modifying or stopping it early can trigger the additional tax retroactively on the distributions taken, plus interest. Someone starting at 52 is committing to a schedule until 59½; someone starting at 58 is committing to five years.

Substantially equal periodic payments may be appropriate for certain individuals seeking retirement income before age 59½. However, the required payment schedule and potential consequences of modifying the arrangement can significantly limit flexibility. The arrangement should be evaluated carefully with a qualified tax professional.

Roth accounts are different

Roth IRAs follow ordering rules that make early access less punitive than many people expect, and more complicated than the headline suggests.

Distributions are generally treated as coming first from regular contributions, which can be withdrawn at any time without tax or additional tax, then from conversions, then from earnings. Each conversion carries its own five-year clock for additional tax purposes, and earnings withdrawn before the account is qualified are generally taxable and subject to the additional tax unless an exception applies.

A properly completed Roth conversion generally does not trigger the 10 percent federal early-distribution tax on amounts successfully converted. However, amounts withheld or distributed to pay taxes that are not converted may be subject to income taxes and additional early-distribution taxes. Withdrawals of taxable converted amounts within the applicable five-year period may also trigger additional taxes if no exception applies. If you are considering conversions and may need access to the money before 59½, the interaction is worth modeling before either happens. Roth conversion rules covers the mechanics, and Roth conversion planning the multi-year side.

Where it goes wrong by accident

Many unexpected additional-tax situations come from mechanics rather than deliberate early withdrawals.

• A failed 60-day rollover. A distribution paid to you and not redeposited within 60 days generally becomes taxable, and the additional tax applies if you are under 59½.
• Mandatory withholding on a plan distribution. An eligible rollover distribution paid to you from an employer plan is generally subject to 20 percent federal withholding. To complete a full rollover you have to replace the withheld amount from other money, and the shortfall is otherwise treated as distributed.
• The one-rollover-per-year rule. Only one indirect IRA-to-IRA rollover is generally permitted in any twelve-month period. Direct trustee-to-trustee transfers are not subject to it, which is one reason direct transfers are often the safer default.
• Rolling the 401(k) too early. The Rule of 55 issue described above.
• Reporting the federal tax and not the state one. The pattern in the Office of Tax Appeals cases above.

How Avinci approaches it

Avinci Wealth Management is a Registered Investment Adviser registered in California, Arizona, Illinois, Texas, and Nevada, firm CRD #327780, headquartered at 23929 Valencia Blvd, Suite 404 in Santa Clarita, with additional offices in Beverly Hills and Woodland Hills. When providing investment advisory services, Avinci Wealth Management is subject to its fiduciary obligations under applicable investment adviser law.

For households retiring before 59½, the sequencing question is not only which account to draw from but which account can be drawn from without an additional tax, and how rollover timing affects that. Under the Retirement Blueprint those questions are modeled together with the rest of the income plan rather than handled as separate administrative steps. Founder Lindahl Lucas is involved in overseeing the development of Retirement Blueprint planning, and tax positions are confirmed with your CPA, who prepares the returns.

Avinci receives advisory fees for investment advisory services. Separately, insurance and annuity products may be offered through our affiliated insurance agency, Lucas Insurance Services, which may receive commissions from issuing insurance companies. This compensation arrangement creates a conflict of interest and is disclosed in our Form ADV. Related reading: RMDs and withdrawal order and how California taxes retirement income.