If you’re facing financial hard times, your retirement funds begin to look like a good source of much-needed cash. In cases of dire emergency, you may indeed be able to make withdrawals from those funds before you reach retirement age. However, the potential short-term and long-term consequences can be severe. Nonetheless, if you must make an early withdrawal from an Individual Retirement Account (IRA) or 401(k), there are certain circumstances under which you can minimize the bite by Uncle Sam.
The COVID-19 pandemic and the 2020 CARES Act have made it easier for taxpayers to withdraw funds from their retirement accounts. Learn more about taking a CARES Act retirement withdrawal HERE.
3 Types of Retirement Funds
There are three primary types of tax-optimized retirement funds in the United States:
- Traditional IRAs
- Roth IRAs
- 401(k)s
Traditional IRAs
Traditional IRAs are drawn from pre-tax earnings. When you deposit funds in a traditional IRA, the taxes on those funds and your earnings are deferred until after you retire, presumably when your income is lower and you qualify for a lower tax bracket.
Roth IRAs
By contrast, Roth IRAs are drawn from post-tax earnings. Because you pay taxes on Roth IRA deposits upfront, you do not have to pay taxes on either the principal or the earnings, provided that your Roth IRA has been open for five years or longer and you are at least 59 ½ years old when you begin making withdrawals.
401(K)
401(k) funds are sponsored by your employer. You can invest either pre-tax earnings or post-tax earnings, with tax implications similar to those for a traditional or a Roth IRA. Many employers match their employees’ contributions dollar for dollar. The catch is that you can’t access your employer’s contributions to your 401 (k) until you are fully vested in the company, which translates to being employed for a certain length of time which varies but five years is common.
For what reasons can you withdraw from an IRA without penalty?
If you are younger than age 59½, taking withdrawals from either a traditional or Roth IRA or from a 401(k) will usually trigger a 10 percent tax penalty in addition to paying any income taxes that are due. However, there are exceptions that vary depending on whether you are withdrawing from a traditional or a Roth IRA or from a 401 (k). You can avoid tax penalties from withdrawing from a traditional IRA even if you are younger than age 59 ½ for the following reasons
- Purchasing a first home.
- Educational expenses for yourself or a family member.
- Death or disability of a family member.
- Covering unreimbursed medical expenses.
- Purchasing health insurance coverage (only if you are not already covered).
To claim one of these exceptions, you will need to complete IRS Form 5329 along with your income tax returns the following year. Even if you avoid the penalty, you will still need to pay taxes on the money you withdraw. This means that you should withdraw enough to cover your needs, plus a little extra for taxes.
Is there a Roth IRA withdrawal penalty?
Yes, penalty-free early withdrawals for Roth IRAs apply to only two circumstances: first–time home purchase or death or disability of a family member. However, the penalty for early withdrawal from a Roth IRA only applies to earnings, since you have already paid taxes on the principal. You will also need to submit Form 5329 along with your tax return.
How do I avoid an early withdrawal penalty on 401(k) retirement funds??
It is possible to make early withdrawals from a 401(k). However, the IRS is especially harsh on early withdrawals from 401 (k) funds. You may make what are known as hardship withdrawals before age 59 ½ for the following reasons:
- Purchase a first home.
- Pay for college for yourself or a dependent.
- Prevent foreclosure or eviction from your home.
- Cover unreimbursed medical expenses for yourself or a dependent.
However, hardship withdrawals from a 401 (k) differ from hardship withdrawals from an IRA. You will be assessed a 10 percent penalty in addition to paying income taxes on your withdrawal. To avoid the 10 percent penalty on early withdrawals from a 401(k), you must fulfill one of the following circumstances.
- Total disability.
- Medical expenses that total more than 7.5 percent of your adjusted gross income (AGI).
- Court order to give the money to a divorced spouse, child, or other dependents.
- Permanent separation from your job (including voluntary termination) during or after the year you turn 55.
- Permanent separation at any age with a plan for equal yearly distributions of your 401(k) (once you begin taking distributions, you must continue them until you reach age 59 ½ or for five years, whichever is longer).
A better option than a hardship withdrawal from your 401(k) may be to take a loan against the value of your 401(k) with an outside lender. The lender places a lien against your 401(k) which remains in place until you repay the loan. Your funds remain in your 401(k), safe from the reach of Uncle Sam. However, if you default on the loan, the lender will have the right to seize your 401(k) to collect payment.
Is it bad to withdraw from an IRA?
It should be clear that IRA and 401k withdrawal should be considered a last resort. Even if you avoid tax penalties, you are depleting the available funds available for your retirement so in this sense, it is a bad idea and if you can avoid it, you should. If you must borrow, borrow enough to cover your obligations plus taxes, and repay the funds as quickly as possible. After all, you are actually repaying yourself – and your future.
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