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Will I be Penalized for Early Withdrawals from my Retirement Account?

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Will I be Penalized for Early Withdrawals from my Retirement Account?

Question-And-Answer

Nick M.-

Everyone falls upon hard times at some point in their life. Unfortunately, those rough patches often come when you least expect them. This leads many people to fall short when it comes to cash in the bank, so naturally, the next place they turn to is their retirement accounts. However, depending on your situation, you may be penalized if you withdraw money from your retirement account before you turn 59.5 years old! So, before you go out and withdraw money from your 401k or IRA, you might want to find out if you are going to be subject to any penalties.

Income Tax

Everyone is familiar with income tax. It’s unfortunately your biggest bill of the year, and it doesn’t go away when you withdraw from your Traditional IRA or 401k. Everyone has to pay their ordinary income tax when they withdraw from one of those accounts. There isn’t a way around it, unfortunately.

Just remember, not all retirement plans were created equal. 401k service providers are required to withhold 20% of your withdrawals for federal income tax. Whereas there is no mandatory withholding for IRAs. With IRAs you will need to set aside some money for taxes, so you’re not scrounging around for cash when April rolls around. Make sure you are conscious of this when making your withdrawal!

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Early Distribution Tax

If you are taking some sort of early distribution, depending on your plan, you may have to pay an early distribution tax. This tax is in addition to your ordinary income tax, and weighs in at a hefty 10%. Before you go out and take an early withdrawal, take a look at the different situations, and see if you’ll have to pay an early withdrawal tax!

With a traditional IRA, the early distribution tax won’t apply if you are withdrawing with the following circumstances:

  • Death of the owner
  • Total and permanent disability of the owner
  • Qualified education expenses
  • For qualified first-time homebuyers, withdrawing $10,000 or less
  • Unreimbursed medical expenses

With a 401k, the early distribution tax won’t apply if you are withdrawing with the following circumstances:

  • Death of the owner
  • Corrective Distributions
  • Total and permanent disability of the owner
  • Unreimbursed medical expenses

Given the times we are going through, the US government had the foresight to realize that large groups of people may be dipping into their retirement accounts. In response to this, the CARES act has waived the early distribution tax on all CRDs (Coronavirus Related Distributions) from January 1, 2020, to December 31, 2020. However, you will still have to pay income tax on CRDs, so keep that in mind!

If you are going to be subject to an early withdrawal tax and you need money, then you may want to consider other options. It may be worth checking into the rates on various loans, like home equity loans or lines of credit. Although they are different from an early distribution, they may be a cheaper option (depending on your interest rate) if you need cash!

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