No one should draw money early from their retirement account unless the circumstances are financially beneficial or there is an emergency need. When not strategically planned, these withdrawals are very expensive and can jeopardize your long-term retirement investment goals. There are two primary retirement savings vehicles investors typically use: an Individual Retirement Account (IRA) and your employer’s Defined Contribution Account, which is often referred to as a 401(k) plan, TSP, or 403(b) plan.
The most flexible account to withdraw money early from is a Roth IRA, which is an IRA account that has been established with after-tax dollars. You may withdraw from this account tax-free if the following events occur:
Principal payments made to a Roth IRA may also be withdrawn so long as the funds have been in the account for at least five years. Also, there are several emergency/special purpose withdrawals to a Roth IRA that may be permitted without a 10 percent penalty, but may be subject to income tax:
If your Roth IRA withdrawals are not made for any of these reasons and you fail to meet the five year holding requirement your withdrawal will be subject to a 10 percent penalty and regular income tax.
Unlike Roth IRA’s which offer income-tax fee distributions, traditional IRA distributions typically are taxable. That said, traditional IRA account owners may withdraw funds for the same special needs cited above (except purchase of first house), but will still be subject to regular income tax. If the withdraw is not for a qualifying event he or she will create a 10 percent penalty on funds withdrawn from the account. If funds are withdrawn for a non-qualified need, the account owner has 60 days to return funds to the account to avoid the tax and penalty.
Withdrawals from your employer’s retirement account are typically more prohibitive. If there is a need for these funds, the optimal means to obtaining these funds is to borrow from your account. IRC Section 72(p) allows participants to borrow from their plan on a tax-free basis as long as the following requirements are satisfied: total loans do not exceed the lesser of 50 percent of the participants vested plan benefit or $50,000.
There is a special rule that allows participants with small accounts to borrow $10,000 without regard to percentage limitation. The loans typically must be paid back over five years unless the loan is used to acquire a principal residence/dwelling. These loans must be paid back to your account at least quarterly. If you fail to make the payments or separate from service during the loan period, the balance is deemed a taxable distribution. This deemed distribution is subject to ordinary income tax and a 10 percent penalty if made prior to 59.5 years of age. If you are not 59.5 years old and you are not borrowing funds from your employer’s retirement account there is a strong likelihood you will be subject to a 10 percent penalty and regular income tax on the distribution.
In service withdrawals from 401(k)’s are typically called hardship withdrawals. A financial hardship is defined as immediate and heavy with no other resources available to meet this need. This distributable amount is equal to the employee’s elective deferrals and vested profit-sharing contributions. If this withdrawal is done the employee will not be able to make contributions for six months to their employer’s plan. Lastly, the hardship withdrawal is again subject to the 10 percent penalty and creates an ordinary income tax liability.