Tax Penalties for Early Retirement Withdrawals

by Debbie Dragon on 18 August 2011 3 comments
Photo: Dan Moyle

There are many different types of funds and plan options that allow you to save for retirement. Many plans are provided by an employer as a benefit. The following are examples of some of the common retirement plan options:

  • 401(k) — This is a retirement savings plan funded by employee contributions and typically matched by employer contributions. These plans are tax free until they are converted or collected.
     
  • Individual Retirement Account (IRA) — This is a plan that allows you to contribute a certain amount during your working years and defers the taxes on the earned interest until the plan is cashed in.
     
  • Pension Plan — A savings account that is arranged to be funded in part or full by your employer on your behalf.

Best of all, most retirement savings plans are tax-deferred until the time when you begin collecting on them after retirement. Encouraging saving for the golden years was the idea behind retirement savings, and thus early withdrawal from a retirement account comes with heavy consequences. (See also: The 10-Step Staircase to a Comfortable Retirement)

The Consequences of Withdrawals

Withdrawing from a retirement fund before retirement age is tempting, especially if an unforeseen situation puts you in financial hardship. But there are heavy penalties that come along with early retirement withdrawals. Consider every option before resorting to borrowing from your retirement savings.

The Internal Revenue Service (IRS) governs the tax-related fees and penalties associated with early withdrawal from your retirement plan. All plan distributors must follow the IRS rules. In addition to the IRS penalties, specific retirement plan administrators may impose additional penalties for early withdrawal — some heavier than others. Many of these penalties add up and end up being very costly.

The following penalties are common among most retirement plans:

  • Being penalized for borrowing from a plan prior to the age of 59-1/2 or before formal retirement occurs.
     
  • The amount borrowed becoming a part of your yearly taxable income.
     
  • A 10% tax placed on early withdrawals unless you can qualify for an exception with the IRS by meeting certain criteria.
     
  • The loss of the potential tax relief from having the money in a structured retirement fund.
     
  • The loss of the potential gains from having the money invested in stocks or bonds. By withdrawing funds, you lose the opportunity to gain on the investments you could have earned from that money.
     
  • In addition to the taxes you must pay on the money, many plans impose an additional penalty for early withdrawal.

These are just a few of the consequences of borrowing from your retirement funds. This is not an all-inclusive list, but rather a general idea of some of the common penalties imposed on those who borrow from a retirement savings plan.

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Alternatives to Taking an Early Retirement Withdrawal

Due to the financial consequences of taking money out of a retirement account early, you should consider alternatives before resorting to the withdrawal.

401(k) Loan

If you have a 401(k) retirement plan, you may be able to take a loan from the account rather than a hardship withdrawal. When you borrow money in the form of a 401(k) loan, it is not taxable as income unless you fail to pay it back. When you pay back your loan, you are paying yourself back.

Roth IRA

If you have a Roth IRA, you are making contributions with after-tax money. This means you can take withdrawals from a Roth IRA at any time without penalty or having to pay income tax. For that reason, if you have more than one type of retirement account, it is always advisable to withdraw from the Roth IRA before any other retirement fund.

Bankruptcy

If you are in an extreme hardship, you may want to consider bankruptcy instead of pulling money from your retirement plan. Money in an employer-sponsored retirement plan or an IRA is excluded from bankruptcy — meaning a creditor cannot take from a retirement account to satisfy your debts.

The best advice is to consider every alternative before making an early withdrawal from any retirement fund. The financial consequences that come along with early withdrawal can be so heavy that making an early withdrawal from any retirement investment is almost never a sound financial decision — or a good way to invest in your future.

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Meg Favreau's picture

Have any readers withdrawn from their retirement accounts prematurely? If so, what was your experience?

Debbie Dragon's picture

I withdrew retirement money early, actually! None of the alternative options for getting money were available to me at the time, and it was a desperate situation a few years ago. It was extremely expensive! I had the equivalent of a 401k, but for government workers (I believe it was a 403b?? but my memory may be failing me!) I had them take taxes out before I "cashed it in"; and then when I filed my income taxes for the year I took the money out of the retirement account, I had to pay a 10% penalty on top of the pre-paid taxes for early withdrawal. As if that wasn't enough, the money put me into a higher tax bracket, causing me to have to pay more in taxes than I had ever paid in previous years!

I highly recommend to anyone considering taking money from retirement early to avoid it if at all possible.

Guest's picture
J

Sometimes it is better to go through the bankruptcy than to dig into the retirement account and accrue boat loads of penalties.