Withdrawal Rules for 401(k) Plans and IRAs
The Internal Revenue Service has instituted rules about the circumstances under which you can take early withdrawals or normal distributions from a 401(k) retirement plan or IRA. The IRS also requires you to begin taking money from your IRA once you've reached a certain age.
Make sure you know what those rules are and the tax penalties you face if you don't follow them.
Most early withdrawals (those taken before age 59½) from a 401(k) are taxed as ordinary income plus a 10 percent penalty. The exceptions include total and permanent disability, loss of employment when you are at least age 55, and a qualified domestic relations order after a divorce. But not only do you lose a good chunk of your savings to taxes when you make an early withdrawal; you also miss out on the potential future savings growth from the withdrawn amount.
Early withdrawals from traditional IRAs are also subject to ordinary income taxes and that 10 percent tax penalty. IRAs have many of the same exceptions to the penalty as 401(k)s, but there are a few differences. You can withdraw from an IRA without penalty if you use the money to pay for 1) qualified higher education expenses, 2) unreimbursed medical expenses above 7.5 percent of your modified adjusted gross income (MAGI) or above 10 percent of your MAGI if you are under age 65, or 3) a first-time home purchase.
A withdrawal from a Roth IRA, which is funded with after-tax contributions, is completely different than one from a regular IRA. Your investments did not grow tax-deferred in a Roth account, and when you take distributions, they will be tax-free provided you are at least age 59½ and have held the Roth IRA for at least 5 years.
There is still a 10 percent tax penalty for early distributions, but that's only on investment earnings. You can withdraw the amount of your original contributions tax-free before age 59 1/2.
That makes the Roth IRA a really flexible savings tool. You could use one to supplement your savings for future non-retirement-related expenses, such as college tuition and room and board or an emergency fund.
If your employer allows it, a 401(k) loan is a better option than an early distribution. There's no credit check, and any fees are generally low if they apply. You must pay yourself back with interest, although at a low-interest rate, and you must do so within five years.
Because you are paying yourself back with after-tax money, you lose one of the main tax benefits of the 401(k). You also miss out on what could be crucial months or years of investment returns.
One of the biggest downsides of a 401(k) loan is that you may have to pay back the loan within 60 days if you leave your job or are terminated. If you don't, your loan balance will be treated as taxable ordinary income and you may also be hit with a 10 percent early withdrawal penalty.
Normal Distributions From Retirement Plans
Normal distributions are those made after age 59½. There is no penalty for withdrawing your money at this point. But if you are invested in a traditional pre-tax 401(k) or regular IRA, you will pay ordinary income tax on the distributions. The benefit of these tax-deferred investment accounts is that you should be retired when you begin taking distributions from them; because you're no longer collecting a salary, you'll be in a lower tax bracket.
When you're 70½, you must begin withdrawing money from your regular IRA account. If you haven't started taking distributions after reaching that age, the IRS will fine you 50 percent of the amount you should have taken out. That amount is called a required minimum distribution (RMB), and if you have a traditional IRA, there's no avoiding it. (Your 401(k) can remain intact as long as you are still working, and Roth IRA holders do not need to take RMBs.) The IRS uses life expectancy tables to determine how much you need to take out each year to avoid the 50 percent tax.
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