By Kristina Russo | American Express Credit Intel Freelance Contributor
5 Min Read | June 26, 2020 in Life
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.
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 However, many early withdrawals also come with a penalty, in the amount of 10% of the funds withdrawn.1 Because of this “double whammy,” the amount of money you’ll actually get from a withdrawal will likely be less than you expect.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.
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.
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.
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.
|Reversing an automatic enrollment||Yes||Sometimes|
|Court-ordered domestic relations payments||Yes||No|
|First-time time home buyers (up to $10,000)||No||Yes|
|Medical costs over 10% of income
|Health premiums while unemployed||No||Yes|
|Military reservists called to active service
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.
Beyond the additional cost of penalties, many experts steer people away from early withdrawals from retirement accounts for four primary reasons:
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.