Should You Withdraw Money Early From Your Retirement Account?

Withdrawal Calculations to Help You Decide

Woman checking her retirement account balance
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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. However, taking an early withdrawal from a retirement plan comes with stiff taxes and penalties.

Suppose your work hours were cut, or you were to lose your job because of an economic recession. You'd need some money to help pay your bills and debt, like your rent or your credit card balance. Why not take an early withdrawal from your retirement account to help pay those bills? That might be an option, but you're going to have to compare it against other options. If the cost of penalty taxes is less than the cost of your alternatives, then it might make sense to take an early withdrawal.

Important

As a part of the CARES Act, passed in March 2020 in response to the COVID-19 pandemic, Congress made it easier to withdraw from retirement accounts. If you contracted the virus or were financially impacted by the pandemic, you may have qualified to withdraw up to $100,000 in the 2020 tax year. The Consolidated Appropriations Act, signed December 27, 2020, extended that rule for 180 days; it expired after June 25, 2021.

What to Consider Before Withdrawing Money

The feasibility of withdrawing money from your retirement account will depend on the specifics of your situation. Some of the factors include:

  • 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retirement plan you have: Contributions to some retirement plans are made in tax-free dollars, at least until they're withdrawn. Once the money is withdrawn, the income tax comes due on the amount withdrawn. These income taxes are in addition to any early-distribution penalties you may face. Roth account distributions are generally not taxable, because they are funded with after-tax dollars.
  • How much you plan to withdraw: The penalty is a percentage, so the more you withdraw, the higher your penalty could be.
  • What the money will be used for: Some purchases might not trigger a penalty tax. For instance, qualified first-time homebuyers might not face a penalty if they withdraw money from an IRA to purchase their home. Certain medical expenses may also qualify. However, expenses like utility 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'd owe on the withdrawal. This penalty increases to 25% if you withdraw the funds from a SIMPLE IRA within two years of joining this type of retirement plan. You might want to wait before withdrawing the money to avoid this penalty if you're close to age 59 1/2.

Exceptions to the Penalty

Allowable exemptions vary 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 also no penalty if the money is used for college tuition or high medical expenses.

Distributions from a 401(k) or 403(b) retirement plan have fewer exceptions. You can dodge the penalty if you are over 55 years old and are retired or have left your job, or if you're using the money to pay for high medical bills (like the IRA exception), or if the withdrawal is part of a divorce settlement.

Income Tax Factors

The IRS treats distributions as ordinary income. This classification means they're taxed at your marginal tax rate. Remember, this is an income tax in addition to any penalty taxes you may pay.

Your marginal tax rate is the rate that applies to each additional dollar of income you earn over a certain threshold. For the 2021 tax year, a single individual pays 10% on income up to $9,950. The next bracket of income, from $9,950 to $40,525, is taxed at 12%. Then, the rate increases to 22% on income from $40,525 up to $86,375, and to 24% on income from $86,375 to $164,925. From there, the tax rate increases to 35% until the income hits $523,600, at which point the highest tax bracket rate of 37% kicks in.

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 to keep pace with inflation.

Tip

Multiply the amount you plan to withdraw by your marginal tax rate to get a quick estimate of your tax liability, and 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

Suppose you qualify for the single filing status, you're age 35 when you decide to withdraw the funds, and your taxable income after taking the standard deduction and personal exemptions is $50,000.

That situation would put you in the 22% tax bracket on the next dollar you take in. If you were to withdraw $10,000 from a retirement account to pay a credit card bill, your income would increase to $60,000, but you'd remain in the 22% tax bracket (because the 22% bracket covers income up to $86,375).

Your federal tax impact on the withdrawal would be $10,000 multiplied by 22%, plus the 10% penalty for early withdrawal. That would give you a total of $3,200 in taxes ($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 for any type of retirement account.

Consider how this scenario would change if your taxable income were higher. If your taxable income after taking the standard deduction and personal exemptions were $86,000, and you were to withdraw $10,000, the first $375 of the withdrawal would be taxed at 22%, but the remaining $9,625 would fall into the higher tax bracket and would be taxed at a rate of 24%.

Warning

You might also be liable for state income taxes and possibly state penalties.

What's the Best Option?

In the lower-income option above, the $3,200 in extra federal taxes is the cost of tapping into these retirement funds. Now that you know the cost, you can compare it to your other options.

You could, for example, leave the debt on your credit card and continue to pay interest on the balance. Suppose your card comes with a 10% annual percentage rate (much lower than the national average, but a simple number to use for this hypothetical example). If you were to keep the balance consistent over the year, you'd rack up interest charges of $1,000 on a $10,000 balance.

Assuming 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 the 20 years it would take to pay off the credit card by making only the minimum payments.

Which is the better deal? Do you want to pay $3,500 now, or $4,888 over 20 years? It's a personal choice, but one more factor to consider is flexibility. You can make the minimum payment on your credit card debt in some months, or pay off more of your debt in other months when you have more income. Taxes, on the other hand, are usually due immediately in one lump sum, though payment plans do exist.

Alternatives to Pulling Money From Retirement Accounts

Many 401(k) and 403(b) retirement plans offer loans to employees. This is a unique feature of these employer-sponsored plans—it isn't available for IRA accounts. These loans can help you meet short-term financial hardships while avoiding the hefty taxes and penalties associated with outright withdrawals.

You might also consider shopping around for a personal loan with a lower interest rate, trying to earn more income with a side gig, or creating a budget to manage your new financial situation.

The information contained in this article is not tax or legal advice, and it is not a substitute for such advice. State and federal laws change frequently, and the information in this article may not reflect your own state’s laws or the most recent changes to them. For current tax or legal advice, please consult with an accountant or an attorney.

Article Sources

  1. Internal Revenue Service. "Coronavirus-Related Relief for Retirement Plans and IRAs Questions and Answers." Accessed Oct. 29, 2020.

  2. MidAmerica. "The Consolidated Appropriations Act, 2021: Impact to Retirement Plans." Accessed July 15, 2021.

  3. Internal Revenue Service. "Retirement Topics - Exceptions to Tax on Early Distributions." Accessed July 15, 2021.

  4. Internal Revenue Service. "What If I Withdraw Money From My IRA?" Accessed July 15, 2021.

  5. Internal Revenue Service. "SIMPLE IRA Withdrawal and Transfer Rules." Accessed July 15, 2021.

  6. Internal Revenue Service. "IRS Provides Tax Inflation Adjustments for Tax Year 2021." Accessed July 15, 2021.

  7. Internal Revenue Service. "Retirement Plans FAQs Regarding Loans." Accessed July 15, 2021.