What happens when you withdraw money early from a retirement account?

When money gets tight, you might start thinking about raiding your retirement nest egg. Before you do, we urge you to consider how much it will truly cost you. By comparing different options, you’ll be able to figure out if withdrawing that money makes financial sense for you.

With few exceptions, withdrawing money early from a retirement account (before you reach age 59½) will trigger a penalty of 10% of the amount you withdraw. That penalty increases to 25% if you withdraw funds from a SIMPLE IRA that you’ve held for less than two years.

In addition to the early withdrawal penalty, any money you withdraw that was tax-deductible when you deposited it into the account, as well as earnings on that money (dividends, interest, and capital gains), will be taxed as ordinary income. This means the money you withdraw will be taxed at your marginal tax rate, so making a large withdrawal from your retirement savings could cause you to move into a higher tax bracket.

Let’s crunch the numbers using the following scenario: Tarek, age 40, qualifies for head-of-household status, and his taxable income after taking the standard deduction and personal exemptions is $120,000, putting him in the 25 percent tax bracket.

If he were to withdraw $10,000 from his retirement account to pay for house repairs, his income would increase to $130,000, but he’d still be in that 25 percent tax bracket. His federal income tax on $10,000 would be 25 percent plus the 10 percent penalty, totaling $3,500. He might also have to pay state income tax and possibly state penalties. (He’s subject to the 10% penalty because paying for house repairs isn’t on the list of penalty exceptions.)

So the minimum cost to Tarek for tapping into his retirement savings will be $3,500, or 35 percent. Tarek will essentially have only $6,500 of his original $10,000 distribution left for repairs. The $3,500 he’ll pay in tax and penalty doesn’t even include what he’ll lose by not keeping his money invested over time, which could be substantially more.

What other options does he have?

He could find financing alternatives that cost him much less than 35 percent. For example, many 401(k) plans allow employees to take a loan from their own account, with the repaid principal and interest returning to it. Note: if he were to leave his current job, voluntarily or otherwise, he would have to pay the full 401(k) loan balance within 60 days or else incur the same tax penalties).

A 401(k) loan could help Tarek pay for his house repairs while avoiding the hefty tax and penalty associated with an IRA withdrawal. He could also try to earn some extra income or even try to work out a financing plan with the contractor.

We generally recommend that our clients leave their retirement funds for when they’ll be needed the most: after age 59 ½, if they become disabled, or if they face a financial disaster for which a penalty exception applies. Otherwise, it can be very costly to withdraw money from your retirement savings.

The information contained in this article is not intended as tax advice and is not a substitute for tax advice. Please consult with a tax professional before withdrawing money from any retirement plan.

Azzad Asset Management

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