Should You Withdraw Money Early From Your Retirement Account?
Withdrawal Calculations to Help You Decide
People often think about tapping into their retirement savings when money gets tight or emergencies arise. Sometimes withdrawing money from a tax-deferred retirement plan can indeed prevent a financial disaster, but taking an early retirement plan withdrawal comes with stiff taxes and penalties.
Figuring out whether cashing out a portion of your retirement savings is worth it involves comparing other options to the taxes and penalties you'll owe.
Let's say your work hours were cut back or you, unfortunately, lost your job because of an economic recession. You need some money to help pay your bills and debt, like your rent or maybe your credit card balance. Why not take an early withdrawal from your retirement account to help pay those bills?
It might be an option—if the cost in taxes for the early distribution is less than the cost of putting those bills on your credit card or simply paying only the minimum on your credit card.
What to Consider Before Withdrawing Money
The feasibility of choosing Option A—taking the distribution—over Option B of just making minimum payments depends on a few factors:
- Your age when the distribution was made: Early distribution penalties apply when you withdraw money from a retirement plan before you reach age 59 1/2.
- What type of retirement plan you have: Contributions to most retirement plans are made in tax-free dollars in many cases...until they're withdrawn. Then income tax comes due on the amount withdrawn in addition to those early distribution penalties. Roth account distributions are often not taxable.
- How much you plan to withdraw: The penalty is a percentage, so the more you withdraw, the more of a penalty you could pay.
- What the money will be used for: The penalty might not apply if you withdraw money to purchase a house, but things like paying bills won't qualify for an exemption.
- What tax bracket you will likely be in at the time of the withdrawal: You'll take a more significant income tax hit if your tax bracket is higher now than you anticipate it will be when you retire.
Early Distribution Penalties
The early distribution penalty is 10% in addition to any income taxes that you'll owe on the withdrawal. This penalty increases to 25% if you withdraw the funds from a SIMPLE IRA and you began participating in that plan within the last two years. You might want to wait before withdrawing the money so you can avoid this penalty if you're close to age 59 1/2.
Exceptions to the Penalty
Allowable exemptions differ by the type of retirement plan you have.
There's no penalty for first-time homebuyers when they withdraw up to $10,000 from an IRA, or for unemployed persons using the money to pay for health insurance. There's no penalty if the money is used for college tuition or for high medical expenses.
Distributions from a 401(k) or 403(b) retirement plan have fewer exceptions—you can only dodge the penalty if you are over 55 years old and are retired or have left your job, to pay for high medical bills, or as part of a divorce settlement.
Income Tax Factors
You'll next want to determine how much tax you'll have to pay on the distribution after you've figured out the penalty. The IRS treats distributions as ordinary income. This means they're taxed at your marginal tax rate.
Your marginal tax bracket is the rate that applies on each additional dollar of income you earn over a certain threshold. As of tax year 2020, a single individual pays 10% on income up to $9,875. The next bracket of income from $9,876 to $40,125 is taxed at 12%. Then the rate increases to 22% on income from $40,126 up to $85,525, and 24% on income from $85,526 to $163,300. The highest tax bracket of 37% applies to incomes of $518,401 or more for single taxpayers.
Making a large withdrawal from a retirement plan might cause you to move up to a higher tax bracket, so you'll want to pay attention to the income ranges for different tax brackets in the current year. The IRS changes them periodically, often annually, to keep pace with inflation.
Multiply the amount you plan to withdraw times your marginal tax bracket to get a quick estimate of your tax liability, then add in any penalty. The total will be how much federal tax you'll owe on the withdrawal. You should estimate any state taxes as well.
A Sample Calculation
Let's say you qualify for the single filing status, that you're age 35 when you decide to withdraw the funds, and that your taxable income after taking the standard deduction and personal exemptions is $50,000.
This would put you in the 22% tax bracket on the next dollar you take in as of 2020. Your income would increase to $60,000 if you withdraw $10,000 to pay down that credit card bill, but you'll still remain in the 22% tax bracket because it stretches up to income of $85,825.
Your federal tax impact would be $10,000 times 22% plus the 10% penalty for early withdrawal for a total of $3,200: $2,200 in income tax and $1,000 for the penalty. You'd be subject to the 10% penalty in our example because paying a credit card bill isn't on the list of penalty exceptions.
And if your taxable income after taking the standard deduction and personal exemptions is $80,000 and you withdraw $10,000, this pushes you into the 24% bracket on $4,475 of that withdrawal—the portion that pushes your income over the 22% bracket extending up to $85,825.
You might also be on the hook for state income taxes and possibly state penalties.
What's the Best Option?
This $3,200 in extra federal taxes assuming total income of $60,000 is the cost of tapping into these retirement funds. What other alternatives do you have?
You can continue to pay interest on the credit card balance. Your card comes with a 10% annual percentage rate, which means that you'll rack up interest of $1,000 over the course of a year on a $10,000 balance. This assumes that the balance remains even over the course of the year.
Using a minimum credit card payoff calculator and making the further assumption that the credit card requires a minimum payment of 2.5% of the balance each month, you would ultimately pay $4,888.25 in interest over 20 years to pay off the credit card.
So what's the better deal? Do you want to pay $3,500 now, or $4,888 over 20 years? That's a personal choice, but the answer might lie in paying off the credit card bill over time. Incurring a large tax bill should be avoided whenever possible. The credit card can be paid off faster whenever extra money is available, or more slowly when finances are tighter. Taxes, on the other hand, are usually due immediately in one lump sum.
Alternatives to Withdrawing Money From a Retirement Account
Many 401(k) and 403(b) plans offer loans to employees, although loans aren't permitted against IRAs by law.
These loans can help you meet short-term financial hardships while avoiding the hefty tax and penalties associated with one or more withdrawals. You might also shop around for a lower interest rate loan, try to earn some extra income, or create a budget to handle the new financial situation.
Leave the retirement funds for when they'll be needed most—when you retire or when you're facing other situations for which a penalty exception applies.
Remember, tax laws change periodically, and you should always consult with a tax professional for the most up-to-date advice. The information contained in this article is not intended as tax advice and it is not a substitute for tax advice.
IRS. "Is the Distribution From My Roth Account Taxable?" Accessed March 20, 2020.
IRS. "Retirement Topics - Exceptions to Tax on Early Distributions." Accessed March 20, 2020.
IRS. "What If I Withdraw Money From My IRA?" Accessed March 20, 2020.
IRS. "SIMPLE IRA Withdrawal and Transfer Rules." Accessed March 20, 2020.
Tax Foundation. "2020 Tax Brackets," Accessed March 20, 2020.