Are you thinking about withdrawing money from your retirement plan early? An estimated 1.5% of 401(k)s and IRAs assets leak out each year through loans, cashouts, and early withdrawals—so, you’re not alone.
But how will this financial move impact your taxes and future? The implications vary from one retirement plan to the next. However, it can be costly.
Before you initiate the withdrawal, here are the tax rules and alternatives you need to know.
What qualifies as an early withdrawal from a retirement plan?
An early withdrawal occurs when you take money out of your retirement plan before you are 59½ years old. In the case of a Roth IRA, it may also occur when you withdraw funds before your account reaches the five-year mark.
What is the penalty for an early withdrawal?
The common penalty for an early withdrawal from a retirement plan is 10% of the amount withdrawn. However, whether you’ll have to pay the penalty or not will depend on your situation and the plan you have.
Employer-sponsored retirement accounts
With 401(k) and 403(b) plans, a 10% penalty goes into effect if the plan holder withdraws money from their plan before they turn 59½. There are some exceptions which will be listed below.
If an individual has a Traditional Individual Retirement Account (IRA), they will again have to pay the 10% penalty unless they qualify for an exception.
A Roth IRA is a bit different. The funds are pre-taxed, so withdrawals—which are returns of original contributions—are not subject to penalties or income tax no matter when they occur.
If a plan holder converts/rolls over funds from a traditional IRA or employer-sponsored retirement plan, they must wait five years or have a qualifying reason to avoid the 10% penalty.
Plan holders will also be charged the 10% penalty if they withdraw earnings before they have had the Roth IRA for five years. Exemptions apply here as well.
Exceptions to the 10% penalty
What are qualifying reasons/exemptions that can enable you to avoid the penalty?
You will not have to pay the additional 10% tax on distributions from employer-sponsored retirement plans (401(k), etc.) if the following circumstances apply:
- You are 59½ or older.
- The distribution is corrective in nature.
- The distribution is made after the death of the plan participant.
- The participant is on total and permanent disability.
- The distribution goes to an alternate payee under a Qualified Domestic Relations Order.
- A series of substantially equal payments are scheduled.
- It is a dividend pass-through from an employee stock ownership plan (ESOP).
- The disbursement is performed because of an IRS levy.
- It qualifies as a tax-free distribution to a qualified military reservist called to active duty.
- The amount is equal to unreimbursed medical expenses.
- The distribution is a rollover.
- It is taken after separation from service at or after age 55.
- You enroll in a plan with auto-enrollment features with allows for permissive withdrawals.
To learn more about any exception, you can check the referenced IRS code section here.
The above-listed exceptions apply to IRAs, SEPs, SIMPLE IRAs, and SARSEP except for those related to corrective distributions, domestic relations, and ESOP.
Further, IRAs, SEPs, SIMPLE IRAs, and SARSEP offer a few unique exceptions to the tax. If you withdraw $10,000 as a first-time home buyer and if you withdraw money to pay for higher education expenses, it will be exempt from the 10% tax.
How do rollovers work?
Rollovers involve taking money out of one qualified retirement plan and putting it into another, or back into the same one. When you do so, you won’t have to pay taxes or penalties as long as you complete the rollover within 60 days of receiving the distribution.
If any part of the distribution is not rolled over, you must report it as income to the IRS and it may be subject to the additional 10% tax.
Drawbacks of early withdrawals
The extra 10% penalty tax is a major disadvantage when withdrawing funds from a retirement account early. However, you’ll also want to consider how a withdrawal will hurt the growth of your tax-deferred savings.
You can only contribute a set amount to your retirement accounts each year. When you withdraw from them early, you may not be able to make up for the amount withdrawn.
For example, in 2020, the total contributions to all of a person’s traditional and Roth IRAs can’t exceed $6,000 or $7,000 if you are 50 or older. Further, the plan holder’s contribution limit on a 401(k) plan in 2020 is $19,500.https://www.irs.gov/newsroom/401k-contribution-limit-increases-to-19500-for-2020-catch-up-limit-rises-to-6500
If you regularly contribute the maximum amount and there is no catch-up payment option, your retirement plan will never fully recover.
So before withdrawing money from your retirement early, be sure to consider alternative ways to get access to funds. You may be able to get a loan that costs you less in the long run.
Alternatives to early withdrawals from retirement plans
A common reason people withdraw money from their retirement early is to pay for unexpected healthcare expenses. However, there are many different scenarios that lead to financial need.
Before deciding to withdraw from your retirement plan, we recommend you look into other options. For example, you may want to take a loan against your retirement plan versus withdrawing the cash.
Further, a personal loan lender may be able to lend you the money at a competitive rate. Another option is to borrow against your home equity. Home equity lenders typically offer very competitive rates and terms.
The right solution will be different for each person. You can find the best value by shopping around. Compare the pros and cons of at least three or four different borrowing avenues.
Get expert assistance with any tax questions
For more help on how an early withdrawal will impact your taxes, enlist the help of a tax expert. Often, they can clarify your situation and help you make the right decision.
Compare industry-leading tax firms now.
Jessica Walrack is a personal finance writer at SuperMoney, The Simple Dollar, Interest.com, Commonbond, Bankrate, NextAdvisor, Guardian, Personalloans.org and many others. She specializes in taking personal finance topics like loans, credit cards, and budgeting, and making them accessible and fun.