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Is Withdrawing Retirement Funds Early a Good Idea?

There are several ways to withdraw from your retirement funds early. Understanding all the costs—today and for your future—can help you decide whether it’s right for you.

By Kristina Russo | American Express Credit Intel Freelance Contributor

5 Min Read | June 26, 2020 in Life

 

At-A-Glance

Retirement account withdrawals prior to age 59½ usually trigger income taxes.

Additional penalties will likely be charged unless the withdrawal qualifies for one of a variety of “hardship” exceptions.

Rules vary among 401(k) plans, and between 401(k)s and IRAs.

Retirement accounts, like 401(k) plans and Individual Retirement Arrangements (IRAs), are designed to help you build a nest egg for the future using features like tax-deferred contributions and tax-free compounding of your earnings. The trade-off for these tax advantages is that you’re not supposed to withdraw retirement funds until after at least age 59½. But sometimes, challenging financial circumstances arise that may make you wonder if you should tap into your retirement fund earlier.

 

The IRS actively discourages people from doing that, but also acknowledges that true financial hardship, which can happen during economic downturns, can make people consider it. So, the IRS set up significant speed bumps in the form of taxes and penalties to deter you from withdrawing retirement funds early, but also allows some exceptions. If you’re unclear about whether you should make an early withdrawal from your retirement account, here are a few things you may want to consider.

 

Can I Take Money Out of My 401(k)?

The IRS expects that all contributions and earnings will remain in a 401(k) until you turn 59½ years old, the plan terminates, or you die or become disabled. Anything else is considered “early” withdrawal. Whenever you withdraw money from a 401(k) plan, early or not, you’ll need to pay income taxes, since you didn’t pay taxes when the money was contributed or when investments within the plan grew in value. However, many early withdrawals also come with a penalty, in the amount of 10% of the funds withdrawn.1 Because of this “double whammy,” the amount of money you’ll actually get from a withdrawal will likely be less than you expect.

 

There are three ways to take money out of most 401(k) accounts. All three require you to contact your plan administrator, fill out paperwork, and may take some time to process. You’ll want to check your Summary Plan Description for specifics on each one, since every plan has its own slightly different policy.

  • Early Withdrawals: Plans differ on whether these are allowed at all, and under what circumstances. Withdrawal amounts may also be limited. The 10% penalty usually applies for taking money out of your 401(k) early.
  • Hardship Distributions: Some plans allow for penalty-free distributions under specific circumstances, within the IRS’ definition of “immediate and heavy financial need.”2 Examples include medical expenses, post-secondary tuition, funeral costs, and costs to purchase a principal residence or avoid being evicted from one. You’ll be required to prove the hardship case in accordance with your plan’s guidelines.
  • 401(k) Loans: Your plan may allow you to borrow against your account, paying both the principal and interest back to yourself over a set period (usually five years). Criteria for loans are typically broad and do not require demonstrating financial hardship. They also tend to have favorable interest rates and are not subject to the 10% penalty. Unfortunately, you forgo earnings on the outstanding amount of the loan. 

 

Often, 401(k) withdrawals can only be made up to the “distributable amount,” which the IRS generally views as the amount you’ve contributed to your 401(k)—not including matching employer funds, if any. This may limit the amount you can access.

 

Pulling Money out of Traditional IRAs is Easy but Costly

Making an early withdrawal from your traditional IRA usually involves a simple phone call and completing paperwork. There are no plan-specific rules, no loans, and no need to prove hardship—it’s just a straight withdrawal. You will be required to pay income taxes on the funds distributed and will incur penalties. Penalties for withdrawals before age 59½ are usually 10% but can increase to 25% depending on the type of IRA account and the timing of the withdrawal.3 However, there tends to be more exceptions for early IRA withdrawals.

 

Exceptions to the 10% Penalty for Early Withdrawals

There are a number of exceptions to the 10% penalty on 401(k) and IRA early withdrawals. The exceptions have changed over time as a result of assorted Congressional actions and have varying start/expiration dates, so it’s a good idea to check with an advisor for specifics. See the chart below for some of the more common exceptions.

 

Exceptions to Penalty for Withdrawing Retirement Funds Early

Exceptions 401(k) IRA
Reversing an automatic enrollment Yes Sometimes
Disability Yes Yes
Court-ordered domestic relations payments Yes No
Education Expenses No Yes
First-time time home buyers (up to $10,000) No Yes
Medical costs over 10% of income
Yes Yes
Health premiums while unemployed No Yes
Military reservists called to active service
Yes Yes

Source: IRS

 

Historically, penalties have been waived and distribution amounts increased in the event of disasters declared by the President of the United States.  This has happened during both local and national events, such as hurricanes, floods, and pandemics.

 

Four Reasons Experts Discourage Withdrawing Retirement Funds Early

Beyond the additional cost of penalties, many experts steer people away from early withdrawals from retirement accounts for four primary reasons:

  1. It is likely that you are in a higher income tax bracket now, while you’re still working, than the one you will be in when you are retired, so you’ll pay more in income taxes by pulling money out now.
  2. The younger you are when you withdraw funds, the more you may lose in terms of compounding earnings growth.
  3. If the value of the underlying investments, like stocks or funds, in your retirement account is down due to market fluctuations, you may need to cash out more shares to get to the amount of cash you are looking for. The more shares you sell, the more you limit a potential upside if the market comes back.
  4. 401(k) accounts and IRAs are usually protected from creditors during bankruptcy. But that protection will be lost on any withdrawn funds.

 

The Takeaway

Withdrawing retirement funds is easier for IRAs than 401(k)s, but you will incur a tax liability in both cases and may also pay a penalty. Even considering the significant number of penalty exceptions, most experts discourage tapping into your retirement account early for a variety of economic and legal reasons. Only you can decide if making a withdrawal from your retirement account is right for your situation. Speed bumps are not stop signs, and many Americans experience them.

Kristina Russo

Kristina Russo is a CPA and MBA with over 20 years of business experience in firms of all sizes and across several industries, including media and publishing, entertainment, retail, and manufacturing.

 

All Credit Intel content is written by freelance authors and commissioned and paid for by American Express. 

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