What are the penalties for early withdrawals from your retirement accounts?

If you’ve been saving for retirement in an IRA, 401(k), or similar, it can be tempting to pull from these accounts when you find yourself going through financial hardships. However, there are hefty tax consequences if you choose to withdraw from these accounts early. In this post, we will walk you through the common types of retirement accounts and explain why you should think twice about withdrawing from them prematurely. 

What is a retirement account?

A retirement account is a savings and investment plan that involves putting money aside and earmarking the funds for when you retire. These accounts differ from regular savings accounts in that there are regulations on how much you can contribute to them, when you can withdraw from them, and how they are taxed.

What are the different types of retirement accounts?

Qualifying retirement plans for tax purposes include the following:

  • An employee plan such as a 401(k)
  • An employee annuity plan such as a 403(a)
  • A Traditional IRA or a Roth IRA
  • A 403(b) or similar program for employees of public schools and tax-exempt organizations

For a more thorough breakdown of all the various accounts, click here. 

What are the tax consequences of withdrawing from a retirement account prematurely?

As some traditional forms of retirement income (such as pension plans and social security) have become less reliable, the government has made strides to encourage individuals to save for their retirement. As a result, the IRS charges a 10% penalty tax on most early distributions from retirement plans. This is to dissuade people from using their retirement savings for anything other than retirement income. Additionally, the funds from the withdrawal will also contribute towards your yearly gross income, and you’ll be taxed on it at your typical effective tax rate. This scenario of being doubly taxed on an early distribution from a retirement carries even more substantial weighting for individuals residing in high income tax states, such as California. 

What qualifies as an early withdrawal?

For the most part, any distribution or withdrawal made before you reach the age of 59 ½ is considered an early withdrawal and, except for some instances, will be subject to the 10% penalty. 

What are the exceptions to the early withdrawal penalties?

According to the IRS, “individuals must pay an additional10% early withdrawal tax unless an exception applies.” Generally, exceptions apply when:

  • The distribution was made after the death of the participant/IRA owner
  • The distribution was made due to total and permanent disability of the participant/IRA owner
  • The distribution was made to an alternate payee under a Qualified Domestic Relations Order
  • The withdrawal was made to cover qualified higher education expenses.
  • The withdrawal was made to cover medical expenses. 
  • The distribution was made because of an IRS levy of the plan
  • The withdrawal was made for certain distributions to qualified military reservists called to active duty
  • The withdrawal was made to assist qualified first-time homebuyers, up to $10,000
  • The distribution was made as an installment in a series of substantially equal payments
  • The distribution was made if for an employee who separates from service during or after the year the employee reaches age 55 (age 50 for public safety employees of a state, or political subdivision of a state, in a governmental defined benefit plan)**
  • The withdrawal is an in-plan Roth rollover, or eligible distribution contributed to another retirement plan or IRA within 60 days

For a more detailed breakdown of the exceptions as they apply to each account type, visit the IRS website.

Different types of retirement accounts have different rules regarding taxes and distributions, but a general rule-of-thumb is that distributions are considered taxable income except for Roth IRA accounts. If you have any questions about the specifics of your case and you would like to speak with a Hall & Company tax expert about your retirement plan, contact us today. For more information covering a host of financial topics, check out our blog.

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