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 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 income 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, the impact they can have, 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 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 the previous two years, a 25% early withdrawal penalty may be applied instead of 10%.
Exceptions to 10% Early Withdrawal Penalties
There are a few situations which allow individuals to take early distributions from their retirement accounts without having to pay 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 you 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 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.
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 on 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 reach retirement.
So should you make an early withdrawal from your retirement funds to pay down debt, finish a home improvement project, or take care of another expense?
Let’s look at a situation and see how it works.
I am a self employed carpenter in a time when there isn’t much worse to be. I had started an addition to my home of 1500 sq ft. and got to the point of being within about 12 grand of finishing it. I can use the square footage to get a refi that would lower the overall payment quite a bit and pay off a card or two. The only issue is that the house has to be finished to qualify for the improved home value and refinance.
I have a self employed retirement account with about $8,000 in it. I have been in this account for about two years and am down about 800 bucks. In other words, no gains. I think that the prior account was a loser for me also. I want to take all but a grand out to finish the addition so I can get the refi loan which may save me nearly $600 a month. Will I have to pay fines on no gains? If so, would it be worth it to take the fines as the savings will be so good on the new refi?
Should I Cash Out My Retirement Account?
Peter, great question. Refinancing your mortgage to save about $600 per month is a great way to increase your cash flow and gives you the option to pay down your mortgage or other debts, increase retirement savings, or save for a rainy day. But withdrawing from your retirement account may not be the best way to do that.
Early Withdrawal Penalties and Taxes
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).
Basically, 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 $7,000, you would only get $4,550 – $5,250. You would lose several thousand dollars in the process. Instead of being able to use that money to finish the repairs on your house, the money would go straight to the government.
Between penalties and taxes, you would only be able to complete less than half your renovation job (it requires $12,000 and you would only get $4,550 – $5,250 from your withdrawal). You would be giving up a huge percentage of your retirement investments and you are also setting yourself back further when it comes to retirement planning.
Impact of Early Retirement Account Withdrawals
Beyond paying the taxes and penalties, early withdrawals also hurt your ability to retire on time.
How will you make up the difference in your retirement accounts?
Will you be able to contribute more toward retirement if you are able to refinance your mortgage? If not, you may be setting yourself back several years and need to work longer because you can’t afford to retire.
These are all big considerations and should factor into your decision-making process.
Regarding investment losses in a retirement plan. I wouldn’t worry much about being down $800 right now. Markets go up and down over time. However, in the long run, stocks usually return a gain. Keep in mind, we’re talking a timeline that usually spans at least 5-10 years.
Over time your investments should regain their value, and hopefully, continue to grow as you get closer to retirement. Remember, retirement investing is a long term goal. With your retirement accounts, you should be thinking in terms of when you can withdraw them without penalties – usually around age 59½.
I can’t tell you which decision to make – but I hope this article helps you make a decision. Best of luck.