When times get tough, one of the assets people tap is their retirement account. A retirement account represents one of the sources of funds that many see as available to them. A financial emergency, such as an accident or a job loss, or a large and unexpected expense, can trigger the thought that the retirement account is the only option.
However, withdrawing money early from a retirement account can come with hefty tax penalties.
What is an Early Withdrawal?
An early withdrawal is one that is taken before age 59.5. For qualified retirement plans like the 401(k) and the IRA, you are supposed to wait until you reach 59.5 to begin taking distributions from your account.
In a Traditional 401(k) or a Traditional IRA, when you withdraw money from your account you are supposed to consider that money as income. This means that you are taxed at your regular income rate for the withdrawal. If the withdrawal adds to your income, you could end up paying taxes in a higher bracket than you expected.
On top of having your early distribution taxed as regular income, you can also be levied an additional tax of 10%. As you can see, your costs can quickly add up if you withdraw your money early from your retirement account. This can represent a serious drain on your wealth now and in the future.
Are there Exceptions?
There are exceptions to the penalties associated with early withdrawal. In some cases, disability, medical expenses, and other circumstances can lead to an avoidance of the extra 10% penalty (although you will still have to pay taxes on the withdrawal). In the case of the IRA, it is also possible to use the money to pay for a first home, or for college expenses.
You can also get an advantage with a Roth account. However, you have to be careful. With the Roth IRA, you can withdraw your contributions at any time, without any penalty. However, you can only withdraw the money you put into your account. If you begin to withdraw your earnings, then you will have to pay taxes and the additional penalty on those earnings.
Before you assume that your situation warrants an exception to the 10% penalty, it is a good idea to consult with a knowledgeable tax professional. Share your situation, and evaluate your options. You want to make sure that you are reporting your early withdrawal properly, in order to avoid further penalties.
If you are subject to taxes and penalties, you will need to fill out Form 5329 in order to figure out what you owe and properly report it. You can also use Form 1099-R to log exceptions and, when done in accordance with IRS instructions, avoid filling out Form 5239.
In the end, it’s best to avoid withdrawing money from your retirement early. An early withdrawal is not only costly, but it also comes with opportunity costs. Once you take that money out, you lose the chance to build your wealth faster. And you usually spend your money enriching someone else.
Try to take advantage of other options before turning to your retirement account.