Breaking the Nest Egg: Tread Carefully with Early Retirement Plan Withdrawals

Tax-deferred retirement plans, such as traditional 401(k)s and IRAs, were designed to make building up a retirement nest egg easier. So they're structured with both carrots (tax-deferred compounding in the account) and sticks (taxes and sometimes penalties on withdrawals) to encourage you to leave your money in the plan. But what if you need to access those funds early?

Whether you're facing a financial emergency, wanting to fund a short-term financial goal or trying to retire at a young age, you need to understand the tax implications of tapping your retirement plan early. By planning carefully and taking advantage of any applicable exceptions, you may be able to reduce the negative tax consequences.

Early Distribution Rules

Withdrawing funds from your retirement account before age 59½ is generally considered an "early distribution." Such a distribution is usually subject to a 10% penalty on top of any income tax due on the withdrawal. This penalty can make early withdrawals costly, especially when coupled with income tax liability.

For example, making an early withdrawal of $20,000 from a traditional retirement account while in the 24% tax bracket would generally result in $4,800 in income taxes and a $2,000 penalty. That means a $20,000 withdrawal would result in just $13,200 of usable funds after taxes and penalties. If applicable, state and local income taxes could further reduce usable funds.

Yet millions of taxpayers make such withdrawals every year and a large portion don't properly report the withdrawal or the 10% penalty on their tax returns. According to a Treasury Inspector General for Tax Administration analysis, in 2021 (the most recent year analyzed), 6.2 million taxpayers received early distributions and 2.3 million didn't properly report them. Another 500,000 reported the distributions but not the 10% penalty. These taxpayers could be subject to interest and additional penalties on top of any unpaid back taxes and early withdrawal penalties.

So, if you do take an early withdrawal from your retirement plan, share the information with your SSB tax professional to ensure that it's properly reported on your tax return and that you pay any tax and penalty due on time.

Exceptions to the 10% Penalty

Fortunately, there are several exceptions to the 10% penalty that may apply to various life circumstances:

Birth or adoption. Up to $5,000 per child can be withdrawn penalty-free to pay qualified birth or adoption expenses.

Disability. If you become permanently disabled and are unable to work, you'll become eligible to take penalty-free distributions. However, a physician must certify that your condition prevents you from performing substantial gainful activity and that the disability is expected to be long-term or indefinite.

Disaster recovery distribution. Up to $22,000 can be withdrawn penalty-free by qualified individuals who suffer an economic loss due to a federally declared disaster area.

Domestic abuse victim distribution. Up to the lesser of $10,000 or 50% of the account balance can be withdrawn penalty-free by a victim of domestic abuse. (This is a new exception beginning in 2024.)

Emergency personal expense. You can take one penalty-free distribution per calendar year for personal or family emergency expenses up to $1,000, as long as it won't leave your account balance below $1,000. (This is a new exception beginning in 2024.)

Medical expenses. If your unreimbursed medical expenses exceed 7.5% of your adjusted gross income for the year, you can take penalty-free withdrawals up to the excess expenses.

Qualified reservist distributions. If you're a military reservist called to active duty for more than 179 days, you can take penalty-free distributions during your active-duty period.

In most cases, you'll still have to pay income tax on the withdrawals and additional rules and limits apply to these exceptions.

3 Exceptions Just for IRAs

Some additional exceptions to the 10% penalty are available for withdrawals from IRAs:

1. First-time home purchase. One of the most popular exceptions allows for penalty-free withdrawals of up to $10,000 from an IRA to buy or build a first home. You're generally considered a first-time homebuyer if you haven't owned a home in the past two years.
2. Higher education expenses. Early withdrawals from your IRA can be used to cover qualified higher education expenses for yourself, your spouse or your children without incurring the penalty. These expenses include tuition, fees, books and room and board, if the student is enrolled at least half-time.
3. Health insurance premiums for the unemployed. If you've lost your job and received unemployment compensation for 12 consecutive weeks, you can take penalty-free distributions from your IRA to pay for health insurance premiums.

You'll still have to pay any income tax due on these withdrawals and additional rules and limits apply.

Substantially Equal Periodic Payments

If you don't qualify for one of the exceptions above, another way to access your retirement plan funds early without incurring the 10% penalty is through Substantially Equal Periodic Payments (SEPP), also known as Section 72(t) distributions. This tax code provision allows you to take penalty-free withdrawals from IRAs and eligible employer-sponsored retirement plans, such as 401(k)s, based on your life expectancy over a set period.

The key requirement is that you must continue these withdrawals for at least five years or until you turn 59½, whichever is longer. Also, for 401(k)s and other eligible employer-sponsored plans, you're eligible only if you no longer work for that employer.

SEPPs can provide a structured way to access retirement funds for early retirees or those with long-term financial needs. But they come with additional rules and limits that must be followed to avoid penalties.

Changing Employers

With an IRA, you can make a withdrawal at any time if you're willing to pay the applicable taxes and penalties. With a 401(k) or other employer-sponsored plan, you can make an early withdrawal in only limited circumstances, such as the exceptions to the 10% penalty discussed earlier. Another situation where you can take an early withdrawal from a 401(k) or similar plan is if you're changing employers. But the withdrawal will still generally be subject to the 10% penalty if you're under age 59½. 

One exception is the "Rule of 55." This rule allows penalty-free withdrawals from your plan if you leave your job during or after the calendar year you turn 55 (50 for certain public safety employees). It applies only to the plan from your most recent employer.

If you've left a job but don't meet the Rule of 55 criteria and decide to roll over your plan into an IRA or your new employer's retirement plan, request a direct rollover. Otherwise, you'll need to make an indirect rollover within 60 days to avoid tax and potential penalties. 

Important: If you don't ask for a direct rollover, the check from your old plan may be net of 20% federal income tax withholding. If you don't roll over the gross amount (making up for the withheld amount with other funds), you'll be subject to income tax—and potentially the 10% penalty—on the difference.

Weigh the Alternatives

Before making an early withdrawal from your retirement savings, check whether you'll qualify for a penalty exception. Also make sure you know how much you'll end up with after taxes (and after the penalty if you won't qualify for an exception). And don't forget about the opportunity for tax-deferred growth you'll forgo on the withdrawn amount. Then consider whether you have alternatives that won't deplete your long-term savings—and may have a lower tax cost.

Contact your SSB tax advisor to help run the numbers on various options to ensure you're making the optimal choice for your financial future—and if you decide to take an early withdrawal, that it's properly handled for federal tax purposes. With careful planning, you can balance your short-term needs with your long-term financial security.

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