Sep 01, 2022
Taking an early withdrawal from your retirement account is a tempting idea. Perhaps you need a new car or have medical bills to pay. Or maybe you are facing an immediate financial hardship like a job layoff or major home repair. Regardless of your reasons, understanding the ramifications of early withdrawals from retirement accounts will help you make the best decision for your situation. Before making early withdrawals, consider the following:
How the withdrawal will be taxed. Generally, withdrawals from traditional IRAs, 401(k)s, 403(b)s, and SEP and SIMPLE IRA accounts are subject to income tax. Even earnings in Roth accounts could be subject to tax. So, if you want $10,000 you may need to withdraw as much as $14,000 to cover federal and state taxes and have enough left over to obtain your $10,000!
Know if penalties apply. Often an early withdrawal from a retirement account before age 59½ is subject to a 10 percent penalty in addition to regular income taxes. Using the previous $10,000 withdrawal example, this means another $1,000 must be withdrawn to account for this surtax. This penalty includes traditional IRA, 401(k), 403(b), SEP and SIMPLE accounts.
Roth IRAs and 401(k)s are different — Because your initial contributions were made with after-tax dollars, only the earnings on your contributions to a Roth are subject to taxes (and the early withdrawal penalty). As a result of this difference, deciding which accounts to use for your distribution may take some planning. You may wish to use your Roth account to avoid the extra taxable income that can drive up your effective tax rate.
Penalty avoidance may be possible — There are some situations that allow for an exemption from the penalty altogether. This includes buying your first home, paying for certain education expenses, and covering health insurance premiums while unemployed. These exceptions can vary by account and may have strict rules and limits.
Consider borrowing the money. An alternative to early withdrawal of retirement funds is borrowing the money from your own 401(k) account. You then pay the principal and interest back to yourself over time. In the end, the cost to you will be administrative fees and some lost growth potential. Check with your employer to see if this is an option.
Know the true tax impact. Remember, every dollar of your withdrawal is taxed at your highest marginal tax rate. So, when withdrawing money from a retirement account, calculate the actual tax impact this distribution will have on your situation. Federal tax rates can range from zero to 37 percent. In addition, the added income created by your early withdrawal could impact your ability to qualify for other deductions and credits that have income thresholds.
There are many situations where early distributions may make sense. But before pulling money out of any retirement account, schedule a tax planning session that analyzes the impact on your situation. Please reach out to the accountants at Terry Lockridge & Dunn. They can be reached in Cedar Rapids at 319-364-2945, or in Iowa City at 319-339-4884.