Due to an error in the Teachers Retirement System of Illinois this year (they phased out some program/benefit and had to refund teachers a portion of what they'd paid in for it), I received a cash payment of about $1700. When it was cashed out, I also had to pay federal income tax on it (about $350). I received a 1099-R in the mail with the information from the transaction. But when I put it into Turbo Tax, I was taxed AGAIN for the income I received, I think because it was considered an "early withdrawal" (the total refund when down another $170 when I put in the Distribution code 1). As none of this was a choice on my part, I was forced to take the money at this time, it doesn't seem fair that I'm being penalized for early withdrawal. Should I be being taxed again in this case when I already paid federal taxes?
I did put the cash towards a variable life insurance policy that I pay into after receiving it, but I'm not sure if that matters.
Even though an early distribution occurred against your will, taxpayers have the option to Rollover qualified funds into an Individual Retirement Account (IRA). The rollover must occur within 60 days and the funds will maintain its tax-deferred status and the penalty would not apply.
"Most retirement plan distributions are subject to income tax and may be subject to an additional 10% tax.
Generally, the amounts an individual withdraws from an IRA or retirement plan before reaching age 59½ are called "early" or "premature" distributions. Individuals must pay an additional 10% early withdrawal tax unless an exception applies.
See this IRS link Retirement Topics - Exceptions to Tax on Early Distributions to see the exceptions available. Form 5329 must be completed to claim a penalty exception.