When you’re dealing with financial struggles, you might need to tap into all of your resources. It can feel really uncomfortable to drain your emergency savings, max out your credit cards, and… finally… start pulling money out of your retirement accounts.
That’s the situation I was in a few years ago when I had a major health crisis. And it felt like I’d never recover physically or financially. But I did, from both setbacks. And you can too.
When you’re at the point where you need to take money out of retirement accounts, it’s important to fully understand how that works. You need to be prepared for the tax consequences, which can be bigger than expected. And you need to know how you can minimize that tax burden. Especially when preserving your resources is so critical.
Understand the Early Withdrawal Rules
Most financial advisors strongly warn against pulling money out of retirement accounts before retirement age.
But when you need that money now to buy food or medicine, pay your rent or mortgage, or cover childcare costs so you can work, it’s the right move. And when you’re in that situation, keeping as much of your money as possible matters. So you’ll want to make sure you do this in the most tax-minimizing way possible.
For traditional (non-Roth) retirement accounts, the contributions are not taxed when you make them. They lower your current taxable income. Because of that, withdrawals before age 59.5 are restricted. When you do take money out, whether it’s early or not, you will have to pay taxes on it.
If you have a workplace-based retirement account like a 401(k), your employer may also restrict early withdrawals. When they do allow early withdrawals, employers are required to withhold 20% for federal taxes.
The wiggle room comes into play with IRS penalties. The IRS imposes a 10% early withdrawal penalty in most cases. But there are some circumstances where that extra 10% gets waived, letting you keep more of your own money.
How Early Withdrawals Work: The Math
In almost all cases, taking distributions from retirement accounts before age 59.5 count as early withdrawals. So when you take that money, you’ll end up getting less cash in hand unless you plan around the taxes and penalties.
For example, say you need $10,000. Between the average 25% for federal and state income taxes and the 10% IRS penalty, you’d end up with just $6,500 available cash.
If you’re dealing with a workplace retirement plan, your employer will withhold 20% right away for federal taxes. If you ask for $10,000, you’ll only end up getting $8,000, for example. The rest, the state income tax and IRS penalty, will be added to your total taxes due for the year. You’ll owe that money unless you specifically withhold it at the time of withdrawal.
To end up with the full amount you actually need from your employer plan, you have to withdraw more than that from your retirement account. For example, if you need $10,000, you’d have to withdraw $12,500.
If you’re taking money out of an IRA, you’ll get the full amount unless you ask for a portion to be withheld for taxes. So you need $10,000, you can withdraw and keep $10,000. But you will still owe federal and state taxes, plus the 10% penalty. And you’ll need to come up with those funds somehow.
I strongly advise working with your tax pro when you’re dealing with this. They’ll know how to minimize the tax hit, help you navigate the no-penalty rules, and may even be able to help you find other resources to pull from.
Know All of the Early Withdrawal Consequences
Before you take an early withdrawal, be aware of all of the potential consequences. They can go beyond the big tax hit. So here’s what you need to know about the possible fallout from early withdrawals… and how you might be able to minimize the damage.
- Your future retirement nest egg will shrink. Retirement accounts grow your money over time, so you end up with (hopefully) a lot more money than you put in. That’s thanks to long-term compounding, how your money earns its own money. Pulling cash out interrupts the compounding process. Meaning your account doesn’t just lose the amount of the withdrawal, but also all of its future earnings. That makes it harder for your nest egg to recover.
- You may lose money. When you take money out of a retirement account, you have to sell investments. If you end up selling when market values are low, you have to sell more shares to get the same amount of cash back than you would if the values were higher. That means you’ll have fewer shares left to grow and earn for you.
- You may get hit with an even bigger tax bill than you expect. Even if you have taxes withheld from your withdrawal, you may end up owing more. The withdrawal amount will get added to your total taxable income, possibly pushing you into a higher tax bracket. That means some of your income may be taxed at a higher rate because of the withdrawal. So, withholding 20% may not be enough to cover the full tax due, especially when you add in the 10% penalty and potential state taxes.
None of this means you shouldn’t take the money if you need it. It just means you need to be aware and prepared.
Exceptions to Early Withdrawal Penalties
The law allows for several exceptions to that nasty 10% early withdrawal penalty that gets added on to the regular tax bill. It works differently if you have a traditional IRA rather than a workplace plan. So we’ll take a look at both.
Traditional IRA
Here’s the rule for traditional IRAs: If you withdraw money before age 59.5, you’ll owe regular income taxes on it plus the 10% penalty. But there are exceptions to that rule that allow you to avoid the extra 10% penalty hit. The exceptions include:
- Up to $5,000 for birth or adoption expenses
- Up to $22,000 for losses due to a federally declared disaster
- The lesser of up to $10,000 or 50% of the account balance for victims of domestic abuse
- Up to $1,000 for personal/family emergency expenses
- Health insurance premiums you pay while you’re unemployed
- Up to $10,000 for a first-time home purchase
- Qualified higher education expenses
If any of the exceptions apply to you (and there are several more exceptions on the official list), you’ll report them on IRS Form 5329 when you file your federal income tax return.
Remember, you’ll still need to pay taxes on the amount you take out. And it’s easier for most people if they have at least some taxes taken out at the time of withdrawal. If you’re really strapped for cash, you can choose to have no taxes withheld. But just know that can stick you with an unmanageable tax bill when you file.
Traditional 401(k)
The rules for early withdrawals from traditional 401(k) accounts tack on an extra issue: your employer’s rules.
In most cases, if you’re no longer working for your employer for any reason, you won’t have any access to your money until you hit retirement age. To get around that, once you leave that job, you can roll the account over into an IRA. You’ll have more control over the money, but all the regular traditional IRA rules will apply.
While you’re still working at that job, your employer gets to decide whether or not you can take early withdrawals or borrow money from your account. Your plan documents should include that information, and you can always ask the HR or payroll department to find out if either of those options is available to you.
The rules are very different for loans and withdrawals, and both come with definite drawbacks. Make sure to give this some serious thought before deciding which option will be better for your finances.
Borrowing from Your 401(k)
Taking a loan from your 401(k) seems like it would be the best option… at least at first glance. But this does come with some big potential consequences. On the pro side, a loan doesn’t trigger taxes. And you’ll be able to pay yourself back with interest, which helps rebuild your nest egg, at least a little.
On the con side:
- Loan repayments are typically deducted from your paycheck automatically, which will reduce your take-home pay.
- The repayments generally start with the very next paycheck after the loan, decreasing your current available cash when you already need extra money.
- Most employers won’t allow you to make any 401(k) contributions while you have a loan outstanding, which can put a big dent in your potential nest egg.
- If you leave your job for any reason, including getting fired or laid off, you may have to pay the loan back in full right away. If you can’t, it will be treated like an early withdrawal, subject to taxes and the 10% penalty. You can potentially minimize that consequence by putting some or all of the loan balance into an IRA, like a rollover, if you can.
Taking an Early Withdrawal from your 401(k)
If your employer allows early withdrawals, you’ll have to pay taxes and the early withdrawal penalty. Remember, your employer has to withhold 20% for federal income taxes from your withdrawal. So factor that in when you’re figuring out how much you need.
You also need to be aware that the hardship withdrawal rules and penalty exceptions are different and more limited for 401(k) plans. First, you can only take out your contributions and employer matches, but not any account earnings. Second, you lose some of the exceptions to the 10% penalty, like higher education expenses and first-time home purchases.
Roth IRA
Roth IRAs work differently than traditional retirement accounts for tax purposes. Roth accounts are funded with after-tax dollars. All the money you put in – you’ve already paid income taxes on it. And since you’ve already paid taxes on your contributions, you won’t have an additional tax hit when you take money out. As long as you follow the rules.
First, the account has to have been open for at least five years.
Second, you will have to pay taxes and early withdrawal penalties on any account earnings you take out before age 59.5.
As long as you only withdraw contributions and not earnings, you won’t have to even think about taxes. That makes a Roth IRA your best option if you need to pull money from your retirement savings. Make sure you withdraw no more than what you put in, or you will end up with a tax and penalty situation.
For example, say your Roth IRA account is worth $100,000. You contributed $50,000 and there are $50,000 worth of earnings. If you take out $50,000 or less, no taxes. If you take out $60,000, you’ll pay taxes and penalties on $10,000 – the earnings portion of your early withdrawal.
Next Steps After the Early Withdrawal
Once your finances start to get back on track, you can start to rebuild emergency savings, regular investment accounts, and other savings, along with your retirement accounts. This will help increase your wealth and financial security. And you’ll have more options if/when another situation comes up where you need an extra cash infusion. (When. It’s always “when” with financial emergencies.)
When you’re replenishing, start with emergency savings first. Your best bet is to put this money into an FDIC-insured high-yield savings account. I keep mine in a different bank than my regular checking and savings, so it’s not so easy to dip into for non-emergencies.
Next step: Contribute to a Roth IRA. You won’t get an immediate tax break, but that will be one more place you can withdraw money without having to worry about taxes and penalties. (Plus, the earnings will be tax-free once you reach age 59.5.)
After that, if you have access to a workplace retirement plan, contribute what you can… especially if they offer matching contributions. Contribute up to the match at first. And you can gradually increase it up to the max as your budget allows.
Finally, start rebuilding your other resources like regular savings and investment accounts. You don’t get any tax advantages with these accounts, but you also have complete control over them. And no penalties when you pull money out.
Figuring Out the Best Way to Take an Early Withdrawal
I think our tax system is stupid (I say that a lot). Mostly it’s ridiculously complicated. So much so that you need a tax professional like me to help ensure you don’t accidentally make a mistake that can damage your financial future.
Because it’s so hard to navigate safely, I offer tax planning and financial coaching services. I have a couple of slots available for planning and coaching right now.
If you’re interested in working together, please click on the button below to contact me. We’ll have a free consultation to see if we’re a good fit for each other, then go from there.
I know exactly what it’s like to need to take an early withdrawal. As I mentioned, I’ve had to do it myself. Between that experience and my long career as a CPA, I can help you figure out the best way to withdraw what you need now, make a plan to replace it, and make sure your financial future is secure so you can retire whenever you’re ready.