Penalties

• The IRS imposes a 10 percent tax penalty on early withdrawals from your SEP IRA. An early withdrawal occurs when you take money out of your account before you reach age 59 1/2. The tax penalty is a one-time occurrence and only applies to the amount that you are withdrawing from the SEP IRA.
  
  

Significance

• The IRS imposes penalties on early withdrawals to prevent people from abusing the tax breaks granted to SEP IRAs. The SEP IRA, as well as other qualified retirement accounts, was implemented to encourage people to save money for after they stop working. However, without the early withdrawal penalties, people would be able to withdraw money at will whether they were saving it for retirement or not.
  
  

Prevention

• In some cases, you may be able to avoid the early withdrawal penalty if you have a qualifying exception. The IRS does not impose the 10 percent penalty if you withdraw the money and use it to pay for college or other higher education expenses, up to $10,000 to buy or build your first home, if you become permanently disabled or if you need to pay for medical insurance when you are unemployed. In addition, if you die before age 59 1/2, your heirs can withdraw money from the account without being penalized.
  
  

Function

• Regardless of whether you have a qualifying reason for taking an early withdrawal, you must file form 5329 (see resources) to document the early withdrawal on your taxes. If you have a qualifying reason, you must list the reason code next to line 2 and the amount of the withdrawal that meets the criteria. You must then calculate 10 percent of the unqualified amount to determine your tax penalty and report it on line 58 of your form 1040 tax return.
  
  

Considerations

• The 10 percent tax penalty on early withdrawals is in addition to, not in place of, any other income tax that you may owe on the withdrawal. You must still report the withdrawal as taxable income when you file your tax return. For example, if you took a $10,000 early withdrawal and were in the 25 percent tax bracket, you would owe $2,500 in income taxes and a $1,000 tax penalty for a total of $3,500, meaning you would only get to keep $6,500 of your $10,000 you took out.