Retirement accounts take one of three forms: The 401(k), or other employer-sponsored qualified plan, where you contribute pre-tax funds and pay taxes on the contributions and gains at withdrawal; the Traditional IRA, where contributions may or may not be deductible now, and gains and deductible contributions are taxed at withdrawal; or the Roth IRA, which is funded with after-tax dollars and allows you to withdraw both contributions and gains tax-free in retirement. Some workplaces offer a Roth 401(k), which is funded with after-tax dollars similar to a Roth IRA. All retirement accounts have one thing in common: they allow you to save a sum of money for retirement while also saving money on taxes either now or later. While there are exceptions, most retirement accounts require you to be 59 1/2 years old before withdrawing from the accounts. In order to enforce this, the government puts penalties in place for anyone withdrawing before the allowed time.

source: jakeandlindsay

In general, withdrawing funds from your retirement accounts before retirement age is a financial no-no. Using the funds now means they won’t be available later, when you might need them. In an emergency, you should tap all other possible funds sources before tapping your retirement accounts. And if it’s not an emergency, you shouldn’t even be thinking about taking money from your future self! If you do need to withdraw early, you should be aware of the costs of doing so. Below, a summary of penalties (and exceptions) for various accounts.

401k Early Distribution Penalties

Please note these rules also apply to 457s, 403(b)s and other qualified and/or employee-sponsored retirement plans.

  • Minimum age for Withdrawal: 59 1/2 if still working, 55 if you have terminated employment, 50 if you have terminated employment and were a public safety employee.
  • Penalty for Early Distribution: 10% of withdrawal amount. You will also pay ordinary income tax on all withdrawals.
  • Exceptions to Penalty: While you will still owe ordinary income taxes, you can avoid the penalty assessed on funds withdrawn before age 59 1/2 if one of the following applies:
    • You die or become totally and permanently disabled
    • The withdrawal is made to satisfy the terms of a qualified domestic relations order
    • You have medical expenses in the year of withdrawal that exceed 7.5% of your income (whether or not you itemized deductions)
    • Your withdrawal is made as part of a series of substantially equal payments paid each year according to your life expectancy.
  • Alternatives to Early Withdrawal: If you really need the funds and still work for the employer who sponsors your 401(k) account, you can consider a loan. This will help you avoid paying taxes and a penalty, and will allow you to pay yourself back over time. Know, though, that you will miss out on some growth from the amount you withdrew, and may be prohibited from making other contributions while you are paying back your loan. In addition, you will owe the entire loan amount if you are fired or quit, or be forced to pay taxes and penalties for a withdrawal. The bottom line – 401(k) loans are not a great option, but are better than outright withdrawals in a true emergency.
  • See more in IRS Publication 575.

Traditional IRA Early Distribution Penalties

  • Minimum age for Withdrawal: 59 1/2
  • Penalty for Early Distribution: 10% of withdrawal amount. You will also pay ordinary income tax on all taxable withdrawals (non-deductible contributions are not taxed at withdrawal since you paid taxes on that money before contribution).
  • Exceptions to Penalty: You can avoid the penalty assessed on funds withdrawn before age 59 1/2 if one of the following applies:
    • You die or become totally and permanently disabled
    • You have medical expenses in the year of withdrawal that exceed 7.5% of your income (whether or not you itemized deductions)
    • You withdraw up to $10,000 for a “first-time” home purchase made by you, a spouse, parent, child or grandchild. “First-time” means that the purchaser has not owned a home in the last two years.
    • You use the funds for tuition, fees or books related to higher education at an accredited school attended by you, your spouse, child or grandchild.
    • You have been unemployed for more than 12 weeks and are using the funds to pay health insurance premiums.
    • The IRS places a levy against your IRA and you are using the funds to pay back taxes
    • Your withdrawal is made as part of a series of substantially equal payments paid each year according to your life expectancy.
  • See more in IRS Publication 590.

Roth IRA Early Distribution Penalties

The Roth IRA early distribution rules are similar to those for a Traditional IRA. Here are the major differences when you make early Roth IRA withdrawals:
  • Your contributions may always be withdrawn tax- and penalty-free.
  • Early withdrawals are made in a specific order: first from your contributions, then from any funds converted from a Traditional IRA, and lastly from earnings.
  • Tax normally does not apply to Roth IRA withdrawals, but that changes if you withdraw before 59 1/2. If your Roth account is less than 5 years old you will owe taxes on the earnings (but no penalty) when using the account for homebuying expenses, or when liquidating the account due to disability or death.  Regardless of the age of the account, those under 59 1/2 will always owe taxes on the earnings (but no penalty) when using the account for higher education expenses.
  • The 5 year clock starts when you open your first Roth, applies to both contributions and conversions, and refers to tax years not calendar years. So if you open a Roth IRA and make a 2011 Roth contribution in March of 2012, then make additional contributions, you can withdraw the amount using the “after 5 years” tax and penalty treatment beginning on January 1, 2016. The conversions have a separate 5 year period, see early Roth IRA withdrawals for more on calculating the 5 year holding period.
  • See more in IRS Publication 590.

The Bottom Line

The rules can be confusing, but here’s the bottom line: Most early withdrawals will lead to a penalty of 10% or more, and in the case of a Roth IRA will lead to tax even when there wouldn’t be any later. So avoid early withdrawals unless you really, really need them. If you meet one of the exceptions, you’ll save yourself the penalty – but will still be robbing your future savings. So instead, save up a good emergency fund before investing heavily in retirement accounts, use FSAs/HSAs to combat medical costs, take advantage of college savings options to pay for higher education, buy a house you can afford and save for a down payment using traditional savings accounts.  You retirement thanks you.

More on Retirement Accounts






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