The IRS offers some awesome tax benefits for people who invest in retirement funds. To entice people to save for their retirement, the IRS offers excellent tax advantages when people contribute to retirement accounts such as 401k plans, IRAs, the Thrift Savings Plan, and other retirement plans. These tax-advantaged plans allow investors to 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 59½ years old.
In addition, distributions from Traditional IRAs, 401(k) plans, the TSP, and most other retirement plans are considered taxable and will be included as income the year you withdraw the money. This means you will also pay taxes on those withdrawals.
Let’s look at the impact of early retirement account withdrawals, their impact, and some other options you may have to avoid these early withdrawal penalties from the IRS.
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 59½, 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.
In some situations, you may 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 the previous two years, a 25% early withdrawal penalty may be applied instead of 10%.
Exceptions to 10% Early Withdrawal Penalties
A few situations allow individuals to take early distributions from their retirement accounts without paying a 10% penalty. These can be broken down into exceptions for IRAs and employer-sponsored plans, such as 401k plans.
Early Withdrawals from IRAs
If you have an individual retirement account (either a Traditional IRA 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 have not owned a home in the last two years.
Note: You can withdraw Roth IRA contributions without penalties, but not the earnings from those contributions. Learn more about Roth IRA withdrawal guidelines to ensure you follow the IRS rules correctly.
Early Withdrawals from Employer-Sponsored Retirement Plans (401k, TSP, etc.)
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 more than 7.5% of your adjusted gross income for medical expenses.
- You received the money from your retirement account in substantially equal payments throughout your lifetime.
You will want to speak with a qualified tax professional or investment advisor to ensure you communicate this appropriately to the IRS when you file your tax return if any of the above apply to your situation.
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.
Most tax software programs can help you report this to the IRS and calculate any penalties or taxes owed. If not, then work with a qualified tax professional. The last thing you want to do is add penalties and fees for failing to file correctly, on top of the 10% early withdrawal penalty.
Should I Withdraw Money From My Retirement Account?
Balancing long-term and short-term financial goals can be difficult – it seems like something always pops up. Whether it’s debt, a major purchase, or an unexpected expense, it can be tempting to dip into your retirement savings for the cash to take care of your new expense.
The problem is unless you are at the IRS retirement age of 59½, withdrawing funds from your retirement account may result in a large portion of the withdrawal being eaten up by taxes and penalties. You are also hurting your long-term financial plans by reducing the amount of money you will have available when you retire.
The Real Costs of Withdrawing Retirement Funds Early!
Every year, I hear many stories about people making early withdrawals from their retirement accounts, which is their worst financial mistake. Here is why it costs so much to make early retirement account withdrawals:
The first thing that is going to get you is the taxes. Qualified retirement plans such as IRAs and 401(k) plans (and others) have some nice tax advantages. When you invest in a Traditional retirement plan such as a Traditional IRA or 401(k), the money is not taxed until you withdraw it.
This is designed to allow you to invest more money upfront and give you years of tax-free growth. When you withdraw that money early, you lose that tax advantage and must pay the taxes immediately.
Early Withdrawal Penalties
That means your withdrawals are taxed, and an additional 10% is taken from the withdrawal to pay the penalty. Double-whammy!
Less Money for Future Growth
Compound interest is the most important thing you have working for your retirement. The more time compound interest works in your favor, the more money you will have when you retire.
Leaving your money in your retirement accounts means you will need to save and invest less money over your remaining working years. It’s better to get ahead now instead of trying to catch up with your retirement savings when you are older.
Possible Market Losses
If your retirement account holdings have depreciated, you will have to pay taxes and early distribution penalties and may be paying them on less money than what you originally invested.
Leaving the money in your investments gives them time to appreciate and regain their previous value and hopefully appreciate beyond your original investment.
How Much Do Early Withdrawal Penalties and Taxes Hurt You?
Making early withdrawals from a qualified retirement account can subject you to early withdrawal penalties, in addition to any taxes you may owe on the income (earnings for Solo 401k plans and SEP IRAs are contributed before paying taxes, as are contributions for an employer-sponsored 401k plan).
You are looking at having to immediately pay taxes and penalties on your withdrawal. For example, you could expect to pay anywhere from 15-25% taxes on the withdrawal, plus 10% penalties, for a total withdrawal of 25-35% less than face value.
So instead of withdrawing $10,000, you would only get $6,500 – $7,500. You would lose several thousand dollars in the process. Instead of being able to use the full amount for your needs, a large portion of the money would go straight to the government.
You would be giving up a huge percentage of your retirement investments and setting yourself back further when it comes to retirement planning.
TSP & 401k Loans Can Be Subject to Early Withdrawal Penalties if Not Repaid
Some people don’t know they can take a loan on their TSP or 401k. Depending on how much is in your 401k, you can secure a loan based on that money. These loans are not subjected to any taxes or penalties. You can contribute to the plan while you’re paying back the loan. In most cases, you’ll be able to take out a loan that is around 50% of the total value of your account.
One of the main disadvantages of taking out a 401(k) loan is that if you were to leave before you paid back the loan, you would be responsible for paying back the remaining balance. Failure to repay the outstanding loan will result in immediate taxes and early withdrawal penalties, which can compound an already bad situation.
Also, when you take out a 401(k) loan, you will receive dollars that have not yet gone through income taxes and then pay that loan back with dollars that have been taxed. When you withdraw the money at retirement, those withdrawals will be taxed again. So any money you pay back into the account from the loan will be subject to double taxation.
On the flip side, there are some benefits to these plans. If you’re ever in need of money, then taking out a loan is going to be a much better idea than withdrawing your money. These loans will give you access to money quickly, at a low-interest rate, and they won’t appear on your credit score.