Early Withdrawal penalty
IRAs and 401k are advantageous to put money in because they are tax-deductible and tax-deferred. You only pay taxes on this money when you pull it out, which typically happens when you reach retirement and need to supplement your Social Security check.
At retirement, most people also fall into a lower tax bracket than when they were working, which makes these retirement accounts even more attractive.
Since these accounts are tax-deferred, you are always going to pay federal and state income tax on this money when you take it out (unless you have a Roth account, learn more about those here). If you wait until you reach age 59 ½, these taxes are all you will pay.
If you choose to make withdrawals from your IRA or 401k before age 59 ½, not only will you pay taxes, but you will also be charged a 10% penalty by the IRS.
When you start to use these retirement savings accounts like bank accounts, they start to fall apart and you lose the advantages that these accounts were designed to give you.
If you end up in a place where you absolutely need the money and have nowhere else to go, make sure you do your research before making withdrawals from an IRA or 401k. You might even qualify for an IRS exception to the penalty if you fall into certain circumstances.
Even if you do fall into one of these exceptions, it is important to realize that you are robbing your future self from the gains that come from these accounts. Compounding is a huge help when it comes to maximizing your savings and making sure you have enough to live off of in retirement. It should be your last resort.
Exceptions to the Penalty for Early Withdrawal from an IRA or 401k
If you use early distributions from your IRA (does not work with 401k) to pay medical insurance premiums for you, your spouse, and your dependent, you might be able to qualify for an exception to the penalty.
- You must have lost your job and received unemployment compensation for at least 12 weeks.
- The distribution must be during the year of unemployment compensation or the year after.
- If reemployed, cannot receive the early distribution more than 60 days after the start of the job.
If you have been laid off, fired, or resigned in the year you turn 55 or after, you may be exempt from the 10% penalty for distributions from your 401k.
This does not work for IRAs, so if you roll your 401k into an IRA, you are not able to take advantage of this.
The age drops to 50 for public safety employees.
Payment for qualified higher education costs, such as tuition, books, fees, and supplies can also get you an exemption to the penalty.
Payment of these costs for your spouse, children, or their descendants will qualify.
This works for IRAs but not 401ks.
Medical expenses that exceed 10% of your AGI (Adjusted Gross Income) can be paid for with early distributions without incurring the 10% penalty from the IRS. This money can be taken from both an IRA and 401k.
This works for expenses for you, your spouse, or a qualified dependant. It only works for medical expenses that are considered qualified by the IRS.
Individuals who qualify as totally and permanently disabled get an exemption from the 10% penalty for all distributions. This works from an IRA and 401k.
You might have to submit evidence from your doctor to the IRS to show that you qualify.
Out of your IRA, you can take up to $10,000 penalty free for first time home buyers. It is your first home if you have not had ownership interest in a home for the past two years.
If married, both you and your spouse can take $10,000 each. This does not work with 401ks.
A Qualified Domestic Relations Order (QDRO) is a judgement or order for a payment of child support or alimony from a retirement account. If this occurs, you do not have to pay the 10% penalty.
Employer permitted, you are allowed to borrow against your 401k without incurring the early distribution penalty. Your employer will set the terms, but the maximum loan amount allowed by the IRS is $50,000 or half of your vested account balance, whichever is less.
Generally, the maximum term for the loan is 5 years. If you leave your employer or are fired, your loan is generally due back right away, within 60-90 days. If you cannot pay it back, you will get a penalty from the IRS.
You are not allowed to borrow like this from an IRA.
2020 Cares Act Exceptions
Due to the passing of the CARES Act, or the Coronavirus Aid, Relief, and Economic Security Act, you may be able to withdraw money from your IRAs and 401(k) to cover bills, loans, and everyday expenses without the penalty.
The bill allows for withdrawals up to $100,000 from retirement savings without the typical 10% penalty. The complete rules for these withdrawals are still being developed.
This should be your absolute last resort in a time like this. Like with any early distribution, you are robbing your future self, as this money now does not have a chance to grow and compound over time.
It is smart to make sure you will qualify for the exemption before you take any distributions. You want to know exactly how much you are going to have to pay in taxes and/or penalties before taking out money.
If you are in a position where you are considering an early distribution, please contact Cardinal or another Certified Financial Planner. We will explore all your options and find the best solution to get you through your current financial situation with the least damage to your future financial situation.
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