Early retirement withdrawals can come with significant tax implications. In addition to paying ordinary income taxes on the amount withdrawn, you may also be subject to a 10% early withdrawal penalty if you take money from a retirement account before age 59½. Withdrawing money from a qualified retirement plan or IRA is tempting when you’re in need of money for medical bills, home improvement projects, major purchases, or any costly life situation. Before cashing out retirement funds, it’s important to understand the potential tax penalties that may apply.
What is an early retirement withdrawal?
An early retirement withdrawal – also known as early retirement distribution – means taking money out of an IRA, Roth IRA, 401(k), or any other qualified retirement plan before the age of 59½. In most cases, early withdrawals are subject to a 10% additional tax penalty on top of any ordinary income taxes owed. Once you reach age 59½, withdrawals are generally no longer considered early, so the 10% penalty typically does not apply. For SIMPLE IRA’s, the early withdrawal penalty may increase to 25% if you take a distribution within the first two years of opening the account.
What are the taxes and penalties on early withdrawals?
In most cases, early withdrawals from retirement accounts are subject to both income taxes and an additional 10% early withdrawal penalty, although certain exceptions may apply. For traditional retirement accounts, contributions are typically made on a pre-tax basis, sowithdrawals are generally taxed as ordinary income in the year it is received. This means the withdrawal is added to your taxable income and taxed at your applicable federal and, in some cases, state income tax rates.
Retirement plan administrators are often required to withhold a portion of the distribution for federal taxes. For example, eligible rollover distributions that are paid directly to the account holder rather than rolled over to another retirement account may be subject to mandatory federal tax withholding. However, withholding is only an estimate of taxes owed and does not necessarily cover your full tax liability. If too little tax is withheld, you may owe additional tax when filing your return. If too much is withheld, you may receive a refund.
Tax implications by account type
The tax implications of an early retirement account withdrawal depend on the type of account you have. Here’s a simple breakdown of common retirement accounts and how they are generally taxed when money is withdrawn early.
401(k) plans
Withdrawals from traditional 401(k) plans are generally taxed as ordinary income. If taken before age 59½, they may also be subject to a 10% early withdrawal penalty. Additionally, plan administrators are typically required to withhold 20% of eligible distributions for federal taxes.
Traditional IRA
Early withdrawals from a Traditional IRA are generally taxed as ordinary income and may be subject to a 10% early withdrawal penalty. Unlike 401(k) plans, mandatory 20% federal withholding does not apply, though voluntary withholding may be available.
Roth IRA
Because Roth IRA contributions are made with after-tax dollars, original contributions can generally be withdrawn tax-free and penalty-free at any time. However, investment earnings withdrawn early may be subject to income taxes and a 10% penalty, depending on the account’s age and the reason for the withdrawal.
SIMPLE IRA
Withdrawals from a SIMPLE IRA are generally taxed as ordinary income. Early withdrawals may be subject to a 10% penalty, but withdrawals made within the first two years of participation may face a higher 25% penalty.
What are the exceptions to the early retirement withdrawal penalty?
The IRS offers exceptions to the 10% tax penalty for certain situations. You still have to report your withdrawal as income, but you don’t have to pay the penalty. Here are some of the common exceptions the IRS allows:
- Medical expenses: This exception only applies if your expenses exceed 7.5% of your adjusted gross income and the funds weren’t reimbursed by your health insurance.
- Separation from service: If you leave your job during or after the year you turned 55, you won’t be penalized. You also won’t be penalized if you leave or retire from a qualified public safety position during or after the year you reach age 50. This exception is only applicable to a qualified retirement plan, such as a 401(k).
- Higher education expenses: You can be exempt from paying the 10% tax penalty if you take money out of a traditional IRA to pay for qualified college expenses including tuition, fees, books, equipment, etc. Room and board are also covered if you’re at least a half-time student.
- First home purchase: Qualified first-time homebuyers can withdraw up to $10,000 from an IRA without incurring the 10% tax penalty. Couples can withdraw up to $20,000 (since IRAs are considered individual retirement accounts).
- Disability: If you become totally and permanently disabled, you may be able to withdraw money from an IRA or qualified plan without paying the early withdrawal penalty. You must be able to demonstrate that your condition prevents you from engaging in substantial gainful activity.
- Military service: Military reservists who withdraw money from an IRA or qualified plan during a period of active duty for 180 days or longer don’t have to pay the 10% tax penalty.
- Death: If you inherit a retirement account from a family member or spouse, you can treat it as your own. Traditional IRA distributions would be taxed if the deceased would’ve paid taxes on the distributions. Roth IRA account holders can withdraw money tax-free if the account is at least five years old. If the account holder passes away before the account is five years old, you will be taxed on distributed earnings until the end of the five-year period.
There are some other exceptions that could save you from having to pay a penalty on your early retirement distribution. Check out the IRS website for complete details.
Are there alternatives to early retirement withdrawals?
Before taking money out of your retirement account, it’s worth exploring options that can help you avoid the 10% early withdrawal penalty. One common alternative is a rollover, which allows you to transfer funds from one retirement account to another without triggering taxes or penalties, as long as the transfer is completed according to IRS rules.
You may also be able to avoid the penalty by taking a qualified distribution from a Roth IRA. To qualify, your first Roth IRA must have been open for at least five years, and the withdrawal must meet an IRS-approved exception, such as a first-time home purchase, disability, or certain beneficiary distributions after the account owner’s death.
How much could an early withdrawal cost?
Imagine Sarah is 45 years old and needs money for a major home repair. She decides to withdraw $20,000 from a traditional 401(k). Because Sarah is younger than 59½, the withdrawal is considered an early distribution. If she is in the 22% federal tax bracket, her costs could look like this:
- Withdrawal amount: $20,000
- Federal income tax (22%): $4,400
- Early withdrawal penalty (10%): $2,000
- Total taxes and penalties: $6,400
Net amount received: $20,000 − $6,400 = $13,600
As a result, Sarah would keep only $13,600 of the original $20,000 withdrawal, not including any state taxes that may apply.
