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Making an early withdrawal from your retirement fund is rarely the best choice. Your withdrawal is likely subject to penalties, income taxes or both. Meanwhile, you'll undermine your own efforts to save for a comfortable retirement.
But if you really need to cover an emergency expense—and avoid an even worse financing alternative—here are some basics on early retirement withdrawals and their consequences.
Early Withdrawal Taxes and Penalties
Unless you qualify for an exception, the IRS assesses a 10% tax when you make an early withdrawal from your retirement account. For IRS purposes, an early withdrawal is one you make before age 59½. You may also need to pay regular income taxes on the withdrawal, depending on which type of retirement account you're tapping.
Here's how penalties and taxes apply:
- Traditional IRA: You'll pay regular federal and state income taxes on your withdrawal in addition to a 10% penalty, since you fund these accounts with pretax money.
- Roth IRA: You may pay a 10% penalty on earnings but won't pay regular income taxes, since you fund a Roth with after-tax dollars. You can withdraw your own contributions at any time without penalty.
- 401(k): The 10% early withdrawal tax also applies to qualified retirement plans, as do regular income taxes on tax-deferred (non-Roth) plan dollars.
Here's an example:
You live in San Francisco and make $60,000 per year, and you withdraw $10,000 from your traditional IRA. You'll pay a $1,000 tax for making an early withdrawal, plus $2,200 (22%) in federal income taxes and $400 (4%) in California state income tax. In this example, you'll net only $6,400 from your $10,000 withdrawal. Meanwhile, that same $10,000 would have been worth more than $32,000 if left in your account untouched for 20 years with a 6% annual return.
Employer Plans May Not Allow Early Withdrawals
You can withdraw money from a traditional or Roth IRA at any time, but your employer's 401(k) plan may not allow early withdrawals or may have rules that restrict your access. For example, some retirement plans allow early distributions if you are experiencing an immediate and serious financial need. If you're thinking about withdrawing money from a retirement plan at work, ask your human resources department or plan administrator whether this is possible.
Two Ways to Avoid Early Withdrawal Penalties and Taxes
You may be able to avoid—or at least reduce—the tax bill on an early retirement distribution by following one of these strategies:
Check Out IRS Exceptions
The IRS makes exceptions to the 10% additional tax if an early withdrawal from an IRA meets certain requirements. Exceptions include distributions used to pay for the following purposes:
- You are totally and permanently disabled.
- You are the beneficiary of a deceased person's IRA account.
- You use the distribution for a qualified first-time home purchase.
- You have unreimbursed medical expenses that exceed 7.5% of your adjusted gross income.
- You are paying medical insurance premiums during a period of unemployment.
- You have qualified higher education expenses that do not exceed your distribution.
- The distribution is due to an IRS levy of the IRA.
- The distribution is a qualified reservist distribution.
- You have withdrawn $5,000 or less upon the qualified birth or adoption of a child.
You may also avoid the 10% additional tax by setting up Substantially Equal Periodic Payments (SEPP) from your retirement account. SEPPs are equal payments made over five years or more to help manage long-term expenses using your retirement funds. Check with your investment company or plan administrator if this sounds like a solution for you.
Withdraw Roth IRA Contributions Tax-Free
You can withdraw money you've contributed to a Roth IRA tax-free at any time. Say you contributed $10,000 to a Roth IRA and, over the years, it gained an additional $2,500 in value. You can withdraw your $10,000 in contributions without paying taxes or penalties.
However, your $2,500 earnings is taxable as regular income if you withdraw it. And, unless your account has been open for at least five years and you are 59½ or older, your withdrawal is also subject to the 10% early withdrawal tax. You may avoid the 10% tax if you qualify for one of the exceptions listed above.
Other Options to Consider When You Need Cash
Whatever your current financial challenge, tapping into your retirement savings shouldn't be your only choice. Consider these ideas for dealing with a cash crunch without pulling money out of your retirement fund:
- 401(k) loan: Some 401(k) plans allow you to take out a loan against your retirement funds, which is not considered a "withdrawal" under the terms noted above. These loans often come with favorable interest rates, but be sure to ask about how the loan will affect your investments and what happens if you're unable to repay it.
- Home equity loan: A home equity loan or line of credit helps you leverage the value of your home to access cash at relatively low interest rates.
- Personal loan: With a personal loan, you can borrow a lump sum of cash, usually at an interest rate that is lower than you'd get with a credit card.
- Credit cards: If you have the available credit, using your credit card to cover purchases or taking a cash advance might be the fastest way to access funds—but it can also be one of the most expensive ways. However, even a relatively high credit card rate might be cheaper than income taxes and a 10% penalty on your retirement withdrawal. Consider looking for a new card with a low introductory interest rate if you have good credit.
- Re-budgeting: Revisiting your budget may help you rein in expenses and find some extra money each month.
- Side income: Generate passive income where you can or consider a side job to make ends meet.
Early Withdrawals Can Be Expensive
Because the taxes you pay can make early distributions an expensive choice, it's important to explore all your options before deciding to make an early withdrawal from your retirement account. This may be a good moment to check your free credit report and score, to get a clearer picture of the loans and credit cards that may be available to you, and which will help you avoid raiding your retirement fund.