The IRS offers some pretty awesome tax benefits for people who invest in retirement funds. To entice people to save for their own retirement, the IRS offers people the opportunity to contribute to 401k plans, IRAs, the Thrift Savings Plan, and other retirement plans and defer paying taxes on a portion of their contributions or withdrawals.
But these tax benefits come with a catch. Almost all retirement accounts have early withdrawal penalties of 10% if you take your money out before you reach the qualified retirement age of 59.5 years old. In addition, distributions from Traditional IRAs, 401(k) plans, TSP, and most other retirement plans are considered taxable income and will be included as income the year you withdraw the money, meaning you will pay taxes on those withdrawals.
10% Early Withdrawal Penalty for Retirement Accounts
Tax Consequences of Early Withdrawals from Retirement Accounts
When you withdraw money from a retirement plan (including IRAs, 401(k) plans, Thrift Savings Plan, 403(b) plans, etc.) before you reach the age of 59.5, you’ll be hit with the early withdrawal penalty of 10%. You may also be hit with a 10% penalty if you withdraw money from a Roth IRA within five years of opening the account.
As mentioned above, withdrawals, or distributions, from many retirement accounts are classified as taxable income. Taxes on this income will apply on top of the 10% penalty so that you are paying 10% of the total amount withdrawn on top of the income tax you pay on the total amount withdrawn. In some situations, you may be able to avoid the 10% penalty, but you cannot avoid having to count early withdrawals from retirement accounts as taxable income.
If you have a SIMPLE IRA that you only began contributing to within two years, a 25% early withdrawal penalty may be applied instead of 10%.
Exceptions to 10% Early Withdrawal Penalties
There are a few situations with allow individuals to take early distributions from their retirement accounts without having to pay a 10% penalty. If you have an individual retirement account (either a Traditional or Roth IRA), the following are allowed exceptions for early withdrawal of your retirement account without having to pay a 10% penalty:
- Completing a direct rollover to your new retirement account
- You become permanently or completely disabled
- You became unemployed and used money from a retirement account for health insurance premiums
- You use the money for your own college expenses or the college expenses of your dependent(s)
- You pay for medical expenses that cost more than 7.5% of adjusted gross income
- The IRS withdrew the money as a tax levy to pay for tax debts owed
- You use up to $10,000 of your retirement account money to purchase a home, and you have not owned a home in the last two years.
If you are withdrawing money from a 401(k) or 403(b) plan, the following situations are considered exempt from the 10% early withdrawal penalty:
- The money was required due to a qualified domestic relations court order, in a divorce or separation agreement.
- You left your job or retired after the age of 55.
- Distributions were received due to the death or disability of the retirement plan participant.
- You used the money to pay for medical expenses that were more than 7.5% of your adjusted gross income.
- You received the money from your retirement account in substantially equal payments over the course of your lifetime.
How to Report Early Withdrawal Penalties
If you decide your financial emergency warrants an early withdrawal from your retirement account, you can figure out the additional tax and penalty owed on Form 1040 or Form 5329.