Dipping Into Your Retirement Savings Before You Retire

Article in Summary

  • Money in a Roth IRA can be withdrawn without penalty
  • Traditional IRA early withdrawals face stiff tax penalties
  • One way to avoid an early withdrawal penalty is to take what is known as a 72(t) withdrawal

We are well advised and encouraged to put money into our retirement accounts and treat it like the proverbial “lockbox” until retirement. But with the difficult economy, many people have had to tap into those funds to survive, often facing a tax hit made worse by the 10 percent early withdrawal for those under age 59 ½. While not recommended except in extreme situations, should you find yourself in that position, it helps to understand the rules and work them to your advantage.

One benefit of tapping a Roth IRA is that the money you contributed can be withdrawn, without penalty or tax, regardless of how old you are or your reason for using it.The IRS treats your withdrawals as “first in, first out.” Beyond that, for withdrawals prior to age 59 ½, the money you’ve earned (if any) on your contributions would be taxed, plus a 10 percent penalty, unless the distribution is used for one of the exception purposes of disability, death, qualified educational expenses, out-of-pocket medical costs (in excess of 7.5 percent of your adjusted gross income), a first time home purchase or to pay health insurance premiums while unemployed (7.5 percent of adjusted gross income doesn’t matter here).

If you are over 59 ½ and it has been more than five years since you started your first Roth IRA (not necessarily the one you are taking money from), all of your withdrawals are tax- and penalty-free. This is the main attraction for the Roth IRA, especially now with the presumption of taxes rising in the future.

Because you benefited from a tax savings when contributing to a Traditional IRA, unless you have one of the exceptions noted above, you will face taxes on the entire withdrawal amount, plus a 10 percent penalty if under 59 ½. If you are in the 25 percent marginal tax bracket then (meaning that each additional dollar you add to income is taxed at 25 percent), you are looking at a 35 percent tax bill. Pennsylvania will add its tax of 3.07 percent on amounts beyond what you contributed and on which you have already paid taxes.

Many people make the mistake of assuming that if taxes have been withheld from the distribution, their tax bill is satisfied. However, the typical withholding amount on a distribution is 20 percent, and the actual tax bill can be as much as 35 percent or more, making for an unpleasant surprise at tax time. (We are assuming all of your contributions were deducted on your taxes; non-deductible contributions have their own rules.)

One way to avoid an early withdrawal penalty is to take what is known as a 72(t) withdrawal, which allows you to take substantially equal periodic payments from your retirement account, subject to tax but not penalty, calculated according to one of three prescribed formulas. Each produces a different payout amount, and you can choose the one you prefer, but the payments must continue precisely according to the method chosen until at least age 59 ½ or for five years, whichever is longer.

If you are facing a hardship, the amounts payable under a 72(t) distribution may not be enough to help. For example, if you are 40 with a $100,000 balance, your monthly payments would range from $191.13 to $360.13, depending on the method chosen, and would need to continue for at least 19 years. If you choose this route, seek professional tax guidance to stay within the IRS rules.

When leaving employment with a 401(k) plan, you have some choices. You may be allowed to leave your account as is, which can be a viable option if the plan has reasonable expenses and good investment choices. Other options may be to take your balance in a lump sum distribution, roll over into your own IRA, or a combination.

If you are over 55 when leaving employment, you are allowed to take the distribution without being subject to the 10 percent penalty (it is still 59 ½ for IRAs).

If you have a new employer with a 401(k) plan, the new plan may also allow you to roll your old 401(k) into it. The advantages to doing so would be account consolidation, and to have the ability to borrow against the balance if the plan allows. Loans from 401(k)s are allowed up to 50 percent of the balance, or $50,000, whichever is less, and have to be paid back with interest (to yourself) in five years or less. Loans for home purchase can be of a longer term. The caution here is that you are paying interest after tax dollars (making them taxed twice in the end), and you are tying up funds today for what should be saved for tomorrow, missing potential growth. Additionally, should you leave employment with an outstanding loan and don’t pay it back when you leave, it is treated tax-wise as if you had received that money as a distribution, complete with tax and penalty, depending on age.

Before making a decision about what to do with your retirement account with your former employer, consider your current and anticipated financial situation, and the likelihood of needing the flexibility for a loan or straight out withdrawal. If you foresee needing to take a withdrawal, then having the funds in your own IRA gives you the most flexibility, since you can take a distribution when needed without having to state a hardship, as you do with a 401(k) withdrawal.

When choosing investments for an IRA from which you may need to withdraw money, be sure not to put the money into an investment vehicle (such as an annuity or mutual fund with a back end sales charge) that penalizes you for taking your money out — it adds insult to injury when you not only have to pay tax and penalty to the IRS on a withdrawal due to hard times, but also a fee to access your money.

About the author

Erin Baehr CFP®, EA

Financial Advice for Everyday Life

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