9 Ways To Avoid The 401(k), IRA Early Withdrawal Penalty

posted on 06-07-2019

When you're faced with serious money sucks -- say, unemployment, a new home or the prospect of funding your child's college education -- it can be tempting to dip into your retirement nest egg.

If you're still some years away from retirement, you may think, I have plenty of time to replace this cash … and it's just sitting there.

But before you start treating your retirement savings like a rainy day fund, think about whether the short-term payoff is really worth the cost.

Withdrawing early from that tantalizing nest egg can lead to a bevy of unexpected taxes. The government has stiff penalties for early withdrawals from most retirement plans in order to ensure that your retirement funds are used for intended purposes.

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So be sure to brush up on the rules for IRAs, Roth IRAs, 401(k)s and 403(b)s if you're thinking about cashing out before that egg has hatched. In the meantime, here's the gist of what you'll face if you do choose to withdraw early:

Penalties For Early Withdrawals

Across the board, these four retirement plans follow the same general guideline: Withdrawals from IRAs, Roth IRAs, 401(k)s and 403(b)s are considered "early distributions" before you reach 59 1/2 years old. There are exceptions to this rule, but assuming that you aren't disabled or saddled with large medical expenses, early withdrawals are hit with a 10% penalty by the federal government, and possibly another 10% withdrawal tax depending on the state and the applicable income taxes on the distribution itself.

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"Those who withdraw early may end up losing 40-50% of their money between taxes and penalties," says Stephany Kirkpatrick, director of financial planning at LearnVest Planning Services.

If you want to avoid this loss, and you foresee such shorter-term expenses as a home purchase or a potential job loss, she recommends putting money into a savings account or a CD rather than investing it. "Then there aren't market risks, taxes or penalties," Kirkpatrick says.

Exceptions For Early Withdrawal Penalties

You may be able to dodge the early withdrawal penalty -- even if you're not yet 59 1/2 -- if you meet certain exceptions. In all of these cases, the distributions will still be taxed as income, unless you have a Roth IRA, which is already comprised of post-tax contributions.

Here are some of the most common exceptions that allow you to withdraw money without getting hit with the 10% penalty:

  • You are disabled.
  • You inherited this retirement account from a deceased person.
  • You have unreimbursed medical expenses that make up 7.5% or more of your adjusted gross income.
  • You're using your distribution to pay medical insurance premiums while unemployed.
  • You, your spouse or dependents have qualified higher education expenses, such as tuition, school fees and books. If the student is enrolled at least part time, distributions can also be used to pay for room and board.
  • Your distribution is used to pay an I.R.S. levy, which allows the government to seize and sell your property to satisfy existing tax debt.
  • You are in the military and have been called to active duty for more than 179 days or an indefinite period. In this instance, the distribution is considered a qualified reservist distribution.
  • You're a first-time homebuyer. If so, the distribution can be used to buy, build or rebuild a first home; the amount is limited to $10,000 per person. Together, qualifying couples can withdraw $20,000 for a first home and avoid the 10% penalty.

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There is one other, less common exception: substantially equal periodic payments. Partaking in an SEPP program allows you to withdraw from an IRA before you reach 59 1/2, if you follow a specific distribution schedule that's determined on your life expectancy. Starting a SEPP program is a complicated choice, with a lot of potentially negative effects, so you must check with a financial adviser before signing up.

Other Early Withdrawal Implications

Even if you qualify for an exception that gets you out of the high tax burden, digging into a nest egg can come with unseen implications, Kirkpatrick warns.

"First of all, you are unwinding the foundation that you built for your retirement savings," she says. The compounded potential gains over a lifetime can be very significant, even for small distributions. This is even more so the case with Roth IRAs, since you've already paid taxes on the contributions.

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And since early withdrawals are taxed as income, you could receive a heftier tax bill than you'd normally expect in April. "Depending on how sizable the new income is, it can throw you into a new tax bracket and change your overall tax liability, which you more than likely won't be anticipating," Kirkpatrick says.

Yes, the government penalties for early withdrawals are harsh. And, yes, it would be a shame to lose as much as half of your withdrawals to fees and taxes. But it's important to understand the motivation behind the government's actions: encourage planning for the future.

"Retirement plans were not designed to be ATMs, which is why there are fees in the first place," Kirkpatrick says. So unless you're in a seriously bad way, focus your efforts on saving up in an emergency fund that you can fall back on instead. This way, you can avoid touching that nest egg and concentrate on the long-term goal: living on a tropical island in retirement, drinking from coconuts the size of your head. It'll be well worth it.

This article was originally published on LearnVest.com:
Why You Shouldn't Withdraw Early From An IRA Or 401(k)

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