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Avoiding Early Withdrawal Penalties

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Retirement

Avoiding Early Withdrawal Penalties

If you are a tax payer like most of us, saving funds for your retirement is definitely your priority, but we all face times when we are forced to dip into our money. Sometimes we just need to take a chunk of our funds to make our lives better. When you do decide to take a distribution or withdraw early from your 401(k), IRA, or any other retirement savings plan, it is mandatory to include this withdrawal in your taxable income. Your early withdrawals may also be subject to a penalty tax of 10% or sometimes even 25%.

Withdrawing funds from a retirement plan prior to reaching the retirement age is something you may have considered at one point or another. The situations in which early withdrawal is permitted are limited. Not many people want to work forever, and saving sufficient money for retirement requires time, planning and dedication. In case you decide to withdraw early, you will not just lose the amount you withdrew, but you will also lose all the potential earnings you may have accumulated over time in case you did not withdraw. So be careful, this could be a double whammy. Having said that, there are times when you may just run out of options and have no other way of averting the impending financial disaster.

401(k)/403(b) Retirement Plans

When you reach the age of 59½, the withdrawals you take from your 401(k)/403(b) accounts are basically penalty free, irrespective of whether you are working or not. But keep in mind that plan administrators can prohibit existing employees to take withdrawals, so it is at their discretion. Also remember that it is mandatory to pay regular income tax on your withdrawals.

You are permitted to take penalty-free withdrawals before the age of 59½ under the following situations:

  • If you are separated from your employment, this could be due to termination, retirement, quitting or permanent layoff, after you have turned 55 or older
  • If you are severed from employment and choose to receive substantially equal periodic payments. These are withdrawals of equal amount, which are based on your life expectancy. They must last for a period of at least 5 years or until you reach age 59½, whichever is later
  • In case you sustain a permanent disability
  • In case you expire and your funds are distributed to your beneficiary
  • If your unreimbursed medical costs are in excess of 7.5% of your adjusted gross income
  • In case you are mandated by a court order to transfer money from your account to your dependent or an ex-spouse

You are also permitted hardship withdrawals in limited situations that are characterized by severe or immediate financial need and you are not able to arrange the funds from elsewhere. A penalty amounting to 10% of the withdrawal amount is charged. The funds that you withdraw can only be used for the following reasons:

  • Eligible medical costs that you incur for yourself and your immediate family that have not been reimbursed
  • Eligible higher-education expenditures that are incurred on your or your immediate family’s education
  • The acquisition of your primary residence
  • Payments that are required to prevent foreclosure of or eviction from your primary residence
  • Eligible repairs for damage that is caused to your primary residence
  • Funeral costs

You also have the option of cashing out your retirement plan when you decide to quit your job and this applies irrespective of your financial situation, but you will incur a penalty of 10% unless you satisfy one of the non-penalty stipulations.

Traditional IRA

When you take a withdrawal from a Traditional IRA, this will deemed as your ordinary income and in case you are below the age of 59½ at the time of the distribution the amount of the withdrawal will be subject to an early withdrawal penalty of 10%. However, the amount withdrawn will be exempt from the early withdrawal penalty in case you satisfy any 1 of the following exceptions:

  • You are planning on using the amount of distribution for the acquisition or rebuilding of your first home or the first home of your eligible family member. The amount is limited to $10,000 per lifetime
  • You suffer a disability prior to the date of the distribution
  • Your beneficiaries receive the assets after you expire
  • You use the proceeds of the distribution for medical costs that were not reimbursed
  • Your distributions are part of a SEPP program
  • You use the proceeds of the distribution for your higher-education expenses
  • You use the distribution funds for paying medical insurance after losing your job
  • The funds are distributed because of a levy imposed by IRS
  • The distributed amount is a return on your non-deductible contributions

Roth IRA

In the case of a Roth IRA no penalty or ordinary income tax is charged on your eligible distributions. For a distribution to be eligible, it has to meet the following 2 conditions:

  • The distribution is made after a minimum of 5 years when you first set up a Roth IRA. However, in case of withdrawals of funds that resulted from a rollover or conversion of your traditional IRA or an employer-sponsored plan to a Roth IRA, the period is 5 years from the conversion date, even if your Roth IRA was established prior to that date
  • You have an eligible reason for the distribution: you are permanently disabled, at least 59½ of age, using the funds for the acquisition of your first-home (the maximum limit in this case is $10,000), or the proceeds are distributed to a beneficiary after you expire

The treatment of your other withdrawals varies depending on what you are withdrawing. As per the ordering rules of IRS, the amount you withdraw first must be deducted from your regular contribution, then, in case they are exhausted, your conversion contribution and finally your earnings.

Under any circumstances you are not required to pay income tax or any penalties on those distributions that are returns of your regular contribution.

You are not required to pay any penalties or income tax on your conversion contribution that is withdrawn following a five year period.  In case of withdrawals before the five year period, no regular income tax is applicable on the withdrawal, but you are required to pay a penalty of 10% unless you satisfy either 1 of the condition for a qualifying reason or 1 of the following exceptions:

  • The amount distributed is used in paying unreimbursed medical costs that are in excess of 7.5% of your gross income
  • The amount distributed is used in paying for your medical insurance in case you have no employment and received unemployment insurance for a minimum of 12 weeks
  • The amount distributed is used in paying for your higher education costs
  • The amount distributed is a part of a group of substantially equal periodic payments
  • The distribution is a result of a levy imposed by the IRS
  • The distribution is a reservist, qualified or disaster recovery assistance

If your earnings withdrawals are not qualified, then they will be subjected to a penalty of 10% and regular income tax unless you satisfy 1 of the exceptions or qualifying reasons. In this situation income tax is charged but penalty is waived.

Apart from the above penalties you will experience a loss of future income in case you decide to take withdrawals from any of your retirement plans or funds in the following forms:

Less Funds for Future Growth

The most important thing that works in your favor by growing your funds is compound interest. The more time your funds stay invested the compound interest will keep working in your favor and you will have more money when you end up retiring.

Potential Market Losses

In case the funds invested in your retirement account holdings have depreciated, not only will you end up paying early distribution penalties and regular income taxes, but you may be paying them on considerably less funds compared to what you initially invested.

Generally speaking, the markets have not performed well over the past few years or so, and it is very likely that a few of your investments have already suffered losses. Keeping your funds invested for a longer period gives them an opportunity to appreciate and not only recover their prior value, but ideally appreciate beyond the initial investment.

If you can, try by any means possible to avoid withdrawing your retirement money for your short term requirements. There are always several other options to arrange the funds you need. These options include taking a part time job, working overtime or arranging funds by organizing a yard sale or disposing unwanted items on eBay or Amazon. Always keep in mind that once you withdraw your funds, they are gone and can be very hard to replace later on.

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