Taxes, Penalties, and Early Retirement Account Withdrawals - Q&A With a Financial Advisor in Greenville, SC

The federal government created qualified retirement accounts (QRAs), such as the 401k and 403b, and individual retirement accounts (IRAs) to provide tax breaks to workers who put money aside for retirement. Those breaks come with a few strings attached, the primary one being a penalty for withdrawals before age 59 ½.

Thankfully, there are ways to avoid penalties for early withdrawals. The rules differ between IRAs and 401ks and traditional and Roth accounts. I'll answer a few key questions about early distributions in what follows, but I invite you to contact me if you would like to discuss your concerns in depth.

Schedule a no-sales conversation with the Global View team to see how we can help.

Q: Are there ways to withdraw from my retirement account early, penalty-free? 

A: Yes, you can avoid the early-withdrawal penalty, although the rules depend on the account type.

IRAs

These are the penalty exceptions that apply to Roth and traditional IRAs distributions made:

• After age 59 ½.
• When you die or become totally and permanently disabled.
• To pay for the qualified purchase of a first-time home (up to $10,000).
• To pay for qualified higher-education expenses.
• If you are unemployed for 12 or more consecutive weeks for health insurance premiums.
• For unreimbursed medical expenses exceeding a set percentage (10%) of your adjusted gross income (AGI).
• Due to an IRS tax levy.
• To a qualified reservist.
• For qualified births or adoptions, up to $5,000.
• As part of a series of substantially equal periodic payments over a specified period.

Qualified Retirement Plans (QRAs -- 401k, 403b, 457)

These are the penalty exceptions that apply to qualified retirement plan distributions made:

• When you die or become totally and permanently disabled.
• As a result of a Qualified Domestic Relations Order (i.e., alimony, child support, etc.).
• As dividends passed through an employee stock option plan.
• As timely corrections to excess contributions and deferrals.
• For unreimbursed medical expenses exceeding your AGI's set percentage (10%).
• Due to an IRS tax levy.
• To a qualified reservist.
• Following separation from service after reaching age 55.
• As part of a series of substantially equal periodic payments over a specified period.

As you can see, there is only a partial overlap between penalty exceptions for IRAs and qualified retirement accounts.

Q: What do taxes look like if I withdraw early? 

A: Traditional IRA and QRA withdrawals (or conversions to Roth accounts), whether early or not, are added to your ordinary taxable income for the year.

Withdrawals of Roth IRA contributions are always tax-free. Withdrawals of Roth IRA earnings are tax-free if you qualify for one of the exceptions enumerated above. However, you may have to pay taxes and penalties on earnings withdrawn within five years of the tax year you opened the Roth account.

Q: What do penalties look like if I withdraw early?

A: The standard penalty for early withdrawals is 10%. Unless you execute a direct trustee-to-trustee rollover to an IRA, distributions from a QRA are also subject to a 20% withholding tax. 

As previously mentioned, you will trigger the 10% penalty if you withdraw from a Roth account earnings made before the end of the five years, beginning with the first tax year in which you contributed (i.e., the Five-Year Rule).

Q: How can I take penalty-free withdrawals from my IRA or 401(k)?

A: Your withdrawal will be penalty-free if you are at least age 59 ½ or you qualify for one of the exceptions enumerated above. 

In addition, you won't trigger an early withdrawal penalty on earnings from your Roth IRA if you withdraw only current-year contributions before the tax filing due date.

You won't pay the penalty when you convert a traditional account to a Roth unless you violate the Five-Year Rule.

Q: Recommendations or options to not withdraw early? 

A: Generally, it's not a good idea to withdraw funds early from a retirement account because you give up tax-free growth of the proceeds and may trigger taxes and penalties. Some QRAs (but not IRAs) may offer a loan option that lets you sidestep taxes and penalties if you repay the loan within a specified period (usually five years). The plan administrator may allow you to borrow up to $50,000 or 50% of your account balance, whichever is less. You must pay interest to yourself for the life of the loan, and the plan may charge additional fees. 

Q: What are other options available to me?

A: Consider a loan if you need cash but don't want to siphon it from a retirement account. I've already mentioned borrowing from your 401k if you have one that permits it. Other alternatives include:

• Personal loans: These are non-collateralized loans that you guarantee with your signature. Interest rates from credit unions and community banks are among the lowest available for this type of loan. Online personal loans can cost more, and payday loans can have astronomical interest rates.
• Home equity loans: If you own your home, you may be able to borrow against the equity you've built up. Your equity equals the home's sale value minus the outstanding mortgage balance. You may be able to borrow as much as 80% to 100% of your equity in the form of a lump sum loan or a home equity line of credit (HELOC) – a revolving credit line similar to credit card cash advances.
• Car refinancing: This is another type of equity loan collateralized by your car. Many dealerships are willing to refinance your vehicle, which means replacing your outstanding loan (if any), using some of the proceeds to repay the old loan, and writing you a check for the rest. Credit unions and banks also offer car refinancing, as do online lenders and P2P marketplaces. 
• Cashing out part of your investment portfolio: If you own securities in a non-retirement brokerage account, you might want to sell some of them. If you sell at a loss, you'll earn some tax benefits. If you sell profitable positions, you'll save on capital gains taxes by selling long-term holdings (i.e., held for a year or longer). 

Q: How do I navigate early withdrawal from my retirement accounts?

A: The IRS offers several publications that lay out all the rules concerning retirement accounts. But the language is not always easy to understand, and research takes some time and effort. As your financial advisor, I will be happy to provide you with the expertise needed to navigate the labyrinth surrounding early withdrawals. I'll also identify possible alternatives that can save on taxes while preserving your retirement nest egg.