17 June 2017
Using tax-advantaged accounts (IRA, 401k, 403b, TSP, etc.) is a great way for most Americans to prepare for their retirement. You can either take a tax break now (traditional) or enjoy your tax break later (Roth). If you have a plan sponsored by an employer you may be able to receive some matching money from the company or agency you work for to increase your retirement savings. That can help you achieve the goals of your retirement plan even faster.
Unfortunately, life does not always cooperate with our plans. Some people find it necessary to tap into their retirement accounts to pay for things prior to retirement. Medical expenses, divorce, accidentally over-contributing to an account, college tuition – if you can think of an expense, someone has probably had to tap into their retirement account to pay for it.
Congress generally imposes a penalty for using retirement funds to pay for non-retirement expenses. Not only do you have to pay income taxes on your tax-deferred withdrawals as though they are regular income, but there is also a 10% penalty tax on top of that. I’ve seen firsthand how shockingly fast those taxes can add up. (There’s a reason I keep a box of tissues on my desk.)
Our government of the people, by the people, and for the people is not completely heartless, however. Congress has made exceptions to the 10% penalty for some pre-retirement withdrawals. But...in typical Congressional fashion, those rules are not uniform. They vary depending on the type of expenditure and the type of account the money comes from. I study taxes for a living and I have a difficult time keeping them straight. That’s why I made the chart below – so I can keep track of when a retirement account distribution is going to trigger a penalty tax.
The chart covers traditional retirement plans only. Roths are different, and more straightforward. The only difference is whether your Roth account is sponsored by your employer (Roth 401(k), Roth 403(b), Roth TSP) or if it is a Roth IRA. In both employer-sponsored Roths and Roth IRAs you receive no tax benefit for the money you contribute to the account. Therefore you can also take it out without paying taxes on it. It’s like putting money into your bank and then taking it out – you don’t pay tax on the deposit or the withdrawal. The catch is that you must have owned the account for at least 5 years before you make the withdrawal. While it works like a bank, the government does not want you using it like a bank. And remember – you can only take out your contributions tax free. Any earnings or profits withdrawn for non-retirement expenses are going to get you the 10% penalty tax.
This brings us to a difference between employer-sponsored Roths and Roth IRAs. With a Roth IRA you can stipulate that you are withdrawing only contributed money. With an employer-sponsored Roth you cannot. Your withdrawal will be part contribution and part earnings, and the earnings part will be subject to taxation if they are deemed not qualified.
For traditional retirement accounts refer to the chart below. I tried to keep it simple, but it is a complex problem that does not readily lend itself to simplification.
|
Your Situation |
Employer Plans (401(k), 403(b), etc.) |
IRA, SEP, SIMPLE IRA and SARSEP Plans |
|
|
You are at least 59 1/2 years old when you withdraw. |
No Penalty |
No Penalty |
|
|
You were automatically enrolled in a plan and you didn't want to participate, so you withdrew your money |
No Penalty |
No Penalty for SIMPLE IRAs and SARSEPs |
|
|
You contributed more than you were allowed to your account and you withdrew some before the deadline |
No Penalty |
No Penalty |
|
|
Original account owner dies and you inherit it. |
No Penalty |
No Penalty |
|
|
You have become totally and permanently disabled. |
No Penalty |
No Penalty |
|
|
Money is withdrawn due to the property settlement of a divorce (Qualified Domestic Relations Order) |
No Penalty |
Not Applicable |
|
|
You use the money to pay for college (or other qualified higher education) |
10% Penalty |
No Penalty |
|
|
You establish and receive a "series of substantially equal periodic payments" from your account |
No Penalty |
No Penalty |
|
|
Dividend pass through from an ESOP |
No Penalty |
Not Applicable |
|
|
Up to $10,000 for Qualified First-time Homebuyers |
10% Penalty |
No Penalty |
|
|
The IRS forces you to take a distribution to pay a tax bill (IRS Levy) |
No Penalty |
No Penalty |
|
|
You used the money to pay unreimbursed (no insurance coverage) medical expenses that exceeded 10% of your AGI |
No Penalty |
No Penalty |
|
|
You used the money to buy health insurance while you were unemployed. |
10% Penalty |
No Penalty |
|
|
You were a military reservist called to active duty for more than 179 days and you made the withdrawal during the time you were called for active duty |
No Penalty |
No Penalty |
|
|
You decide to withdraw your IRA contribution before the due date of the tax return |
Not Applicable |
No Penalty |
|
|
You withdraw the EARNINGS on an IRA contribution |
Not Applicable |
10% Penalty |
|
|
You withdrew the money and then contributed it to another qualified account as a qualified rollover within 60 days of the withdrawal.*
|
No Penalty |
No Penalty |
|
|
Employee takes withdrawals after he or she separates from service (quits/retires) during or after the year the employee reaches age 55 (age 50 for public safety employees of a state, or political subdivision of a state, in a governmental defined benefit plan) |
No Penalty |
10% Penalty |
Probably the most important thing I can tell you is that if you have questions – ask! And ask BEFORE you take money out of your retirement account. Once you make the withdrawal you nearly always have to live with the consequences. Give me a call if you have questions.
* This is also known as an indirect rollover. You can only do 1 indirect rollover per 12-month period. If you do more than 1, then you are going to pay taxes and penalties on the subsequent withdrawals.
