During tough times like these a lot of people are running into situations where they may h ave to take an early distribution from their retirement plan to help pay for bills, a home mortgage or some other expense. While it’s not typically something you should probably do, in some cases it’s unavoidable. Today I thought I would look at some quick facts about early distributions, sent to me by the IRS.
Top Ten Facts about Taking Early Distributions from Retirement Plans
When you take an early distribution from your retirement plan there will often be a tax impact and penalty to taking money out early. Here are ten facts about early distributions that the IRS sent out in their monthly newsletter.
- Payments you receive from your Individual Retirement Arrangement (IRA) before you reach age 59 ½ are generally considered early or premature distributions.
- Early distributions are usually subject to an additional 10 percent tax.
- Early distributions must also be reported to the IRS.
- Distributions you rollover to a rollover IRA or qualified retirement plan are not subject to the additional 10 percent tax. You must complete the rollover within 60 days after the day you received the distribution.
- The amount you roll over is generally taxed when the new plan makes a distribution to you or your beneficiary.
- If you made nondeductible contributions to an IRA and later take early distributions from your IRA, the portion of the distribution attributable to those nondeductible contributions is not taxed.
- If you received an early distribution from a Roth IRA, the distribution attributable to your prior contributions is not taxed.
- If you received a distribution from any other qualified retirement plan, generally the entire distribution is taxable unless you made after-tax employee contributions to the plan.
- There are several exceptions to the additional 10 percent early distribution tax, such as when the distributions are used for the purchase of a first home, for certain medical or educational expenses, or if you are disabled.
- For more information about early distributions from retirement plans, the additional 10 percent tax and all the exceptions see IRS Publication 575, Pension and Annuity Income and Publication 590, Individual Retirement Arrangements (IRAs). Both publications are available at IRS.gov or by calling 800-TAX-FORM (800-829-3676).
Those are 10 quick facts about taking an early distribution on your retirement account, important points to remember.
Important points to remember:
- If you take an early distribution, usually there is going to be a hefty 10 percent penalty to pay.
- The distribution may be taxable and you’ll need to pay taxes at your normal rate on the money.
Right away not only are you losing the money from your retirement account and losing the effects of compounding interest, you’re also taking a hit through the tax penalty and taxes you’ll need to pay. Sometimes that can be a 30-40% hit! So if you can avoid taking money out early, do it! Otherwise, try to pull money from non-taxed accounts like your Roth IRA.
Have you taken money out of a retirement account before you reached retirement age? Did you end up having to pay taxes and penalties, or did you fit into one of the exceptions? Tell us your thoughts in the comments!
Good, sound list Pete – the exceptions to the early distribution penalty are key for sure – If someone needs to tap their retirement funds, they need to have a good handle on those exceptions!
Jason @ Redeeming Riches´s last post ..5 Things Dora the Explorer Teaches Us About Personal Financial Planning
Thankfully, I haven’t taken money out of my retirement accounts. But I know people who talk about possibly taking money out early for reasons that don’t fall into an exception, and thus force themselves to pay the 10% penalty.
It’s actually a bit painful to hear this. Retirement accounts should be used for their designed purpose, which is to fund retirement. Unless it’s an absolute critical emergency, why lose the impact of your money compounding with interest?
If one doesn’t have any income in a year (e.g. unemployed, want to take a year off, etc.), then the 10% penalty can be viewed a tax and if the amount you pull out falls below the taxable income level well then your “tax” is really just the 10%. For example, in my situation, I don’t pay taxes unless my income is more than $45,000 per year. If I pull out $40,000 from my retirement accounts, then I pay $4,000 for access to my money netting $36,000. Now let’s really put a twist on this. If I had “earned” that $40,000 at a job (rather than taking it out), I would have had to pay 7.65% (Social Security and Medicaid). This means I would net $36,940. A whopping difference of $940!! Not much in the grand scheme of things. So, viewing the 10% as an access path to income when you can fall below the income tax thresholds, to me, is a most excellent way to free your money from the locked in system before you’re 59.5 years old.
SailboatFamily´s last post ..Lifeline Netting
Hey Peter,
Thanks for the list! I think that most people don’t realize how much it is actually going to cost them if they do take out their money early.
The 10% penalty is put in place to scare people away from taking their money out early, yet so many still do.
Crazy people
Cheers!
Brandon
Brandon Schmid´s last post ..Tips on Budgeting– A dollar saved is 2 dollars earned