I have a 10% tax penalty on the taxable portion of an early distribution from a variable annuity, since I am not 59.5 years old yet. I also have an education credit of $2500 of which $1500 is nonrefundable but I have no tax liability against which to offset it, except for the previously mentioned 10% penalty. My tax software does not allow me to use the nonrefundable credit against the 10% tax penalty. Is this a software mistake or the way it should be?

What is the rationale behind this 10% penalty?
The money I contributed to the annuity is after tax or tax free, so it is a non-qualified contract. The earnings will be taxable regardless if I withdraw now or after I retire.If I withdraw now, I will defer taxes for less time and pay more taxes, since my tax rate during retirement will be lower. Why the penalty on top of all that?
Thank you so much,

Gabriel

Gabriel:

No, it is NOT a software mistake. The 10% Early Withdrawal Penalty is a punitive tax levied to discourage people from cashing their retirements in early. This being the case, this tax is due even if your deductions, credits and exemptions completely offset all income and you have no other tax liability.

In short, the 10% Early Withdrawal Penalty can in no way be mitigated by other credits, deductions or exemptions.

Now, if the annuity was funded with after-tax money, then you should only pay the 10% Early Withdrawal Penalty on the EARNINGS from the annuity, not the initial amount invested. You can show this using Form 5329 to differentiate between your initial investment and the amount distributed. If the amount distributed is LESS than the investment amount, then there should be NO 10% Early Withdrawal Penalty.

Thank you!. So this means that this 10% penalty would apply even if earnings from the annuity were not taxable due to my being a non-resident alien for tax purposses,am I right? I was a resident for 2009 tax year so I paid both incometax and penalty

Now we have to look at the tax treaty between the U.S. and your home country, if there IS such a treaty.

So what IS your home country?