Why did my federal refund decrease by almost $3,000 when I entered my 1099R for just under $13,500?

[taylor32e]

We took an early withdrawal from an IRA for just under $13500.  We paid the 10% tax upon withdrawal of the money.  We understand that there is an additional 10% tax imposed.  However, what we do not understand is why our federal return would decrease from about $3500 to $500 and our state return would go from a positive to a negative balance?  Why are we taking such a hit for this withdrawal?  What additional fees are being imposed?

[AnthonyC · Accepted solution]

The tax withheld (10%) when you withdrew the amount was not the actual tax due on the distribution.  The amount of the withdrawal gets added to all your other taxable income and you are taxed on the total amount of your taxable income.

So, just using a simple example, if your marginal tax bracket was 25%, then that additional amount would be taxed at 25% rate (would be an additional $3,375 to your taxes due in your case).  By default, most retirement companies withhold at a lower rate (such as 10%) unless you instruct otherwise (most retirement distributions are during retirement when taxpayers generally have lower tax rates).

In addition, this extra taxable income may have made your AGI higher and caused you to lose eligibility for other deductions and credits.  And, as you have mentioned, there is also a 10% penalty for early withdrawal. 

[fanfare]

3000 / 13500 is .2222 which puts you in the new 22% tax bracket.
You already paid the penalty when you took the money out.