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 retirement plan withdrawal comes with stiff taxes and penalties.

Let's say your work hours were cut or you lost your job because of an economic recession. You 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?

This 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.

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 qualify to withdraw up to $100,000 in the 2020 tax year. While qualified individuals won't pay penalty taxes, the withdrawals may impact their income tax bracket, so check the details on this and other COVID-related stimulus measures before withdrawing money.

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 59½.
  • 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retirement plan you have: Contributions to some retirement plans are made in tax-free dollars, at least until they're withdrawn. Once the money is withdrawn, the income tax comes due on the amount withdrawn.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 face. Roth account distributions are often 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 more penalty you could pay.
  • What the money will be used for: Some purchases may not trigger a penalty tax. For instance, qualified first-time homebuyers may not face a penalty if they withdraw money from an IRA to purchase the 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'll 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 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 high medical expenses.

Distributions from a 401(k) or 403(b) retirement plan have fewer exceptions. However, exceptions do exist. 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 pay.

Your marginal tax bracket 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 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. All of these dollar amounts are doubled for married people filing jointly.

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.

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, 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.

This situation would put you in the 22% tax bracket on the next dollar you take in. If you withdraw $10,000 from a retirement account to pay a credit card bill, your income would increase to $60,000, but you'll 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. This gives 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 changes if your taxable income is higher. If your taxable income after taking the standard deduction and personal exemptions is $86,000 and you withdraw $10,000, the first $375 of the withdrawal will be taxed at 22%, but the remaining $9,625 falls into the higher tax bracket and will be taxed at a rate of 24%.

You might also be on the hook 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. Let's say your card comes with a 10% annual percentage rate (this is much lower than the national average, but it's a simple number to use for this hypothetical example). If you keep the balance consistent over the year, this means that you'll rack up interest charges of $1,000 over the year 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 20 years it would take to pay off the credit card by making only the minimum payments.

So what's 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 some months, or pay off more of your debt in other months when you have extra 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 tax and penalties associated with outright withdrawals.

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

The information contained in this article is not tax or legal advice and 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 the law. 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. Internal Revenue Service. "Retirement Topics - Exceptions to Tax on Early Distributions." Accessed Oct. 29, 2020.

  3. Internal Revenue Service. "What If I Withdraw Money From My IRA?" Accessed Oct. 29, 2020.

  4. Internal Revenue Service. "SIMPLE IRA Withdrawal and Transfer Rules." Accessed Oct. 29, 2020.

  5. Internal Revenue Service. "IRS Provides Tax Inflation Adjustments for Tax Year 2021." Accessed Oct. 29, 2020.

  6. Internal Revenue Service. "Retirement Plans FAQs Regarding Loans." Accessed Oct. 29, 2020.