One of the questions my clients most frequently ask is “is there any way I can take money out of my retirement plan without being taxed?” The short answer is no.
There may be exceptions for after-tax contributions and your company may permit loans against the funds, but put simply, if money goes into a plan before being taxed, distributions come out taxable as ordinary income.
What Types of Retirement Plans Are There?
There are many retirement plans. Some plans are sponsored by an employer, for example: 401K, 403b, defined benefit (pension), SEP (Simplified Employee Pension), Simple IRA, SARSEP (Salary Reduction Simplified Employee Pension) to name a few.
Some plans can be taken out directly by an individual. These include a traditional IRA, Roth IRA and Solo 401K.
Generally, the amount an individual withdraws from an IRA or retirement plan before reaching age 59 ½ are called ”early” or ”premature” distributions. Individuals must pay an additional 10% early withdrawal tax penalty unless an exception applies (more about this below). The early withdrawal penalty is in addition to the tax due on the amount of the money withdrawn.
A 457b plan, (deferred compensation plan) is not subject to the 10% penalty unless distributions are attributable to rollovers from another type of plan or IRA. Simple IRA distributions incur a 25% additional tax instead of 10% if made within the first 2 years of participation.
What Can I Withdraw Without Paying a Penalty?
A distribution made by someone older than 59 ½ does not incur the early withdrawal penalty as outlined in the IRS code. However, the total amount withdrawn from your retirement account will be taxed as ordinary income. For example, if you are over 59 ½ and have $30,000 of income from a part-time job and/or investments and you take a $10,000 distribution from your IRA, your total taxable income before deductions or exemptions is $40,000. If you are under 59 ½, your early withdrawal penalty would be 10% of the $10,000 withdrawal or an additional $1,000. So, you pay tax on the withdrawn amount ($10,000), plus an early withdrawal penalty ($1,000).
Confusion regarding taxation might arise when people mistake the withdrawal amount (distribution) with the early distribution penalty. They are two very different components of the tax code and withdrawal process.
What Exceptions Apply?
Here is a rundown of when your withdrawal may generally be exempt from the 10% penalty.
- If you are younger than 59 ½ and made an excess contribution to a Qualified Plan, you are allowed a timely correction (There is an over-contribution excess penalty if you miss the maximum amount).
- If the participant or IRA owner dies.
- If you become completely and permanently disabled, you can take distributions without penalty.
- If you’re subject to a Domestic Relations Order (divorce or other court-mandated payment) to an alternate payee, withdrawals may be exempt.
- Withdrawals for education area little different in that the penalty will be waived for an IRA, SEP, Simple IRA, SARSEP but not usually for a Qualified Plan like a 401K or 403b.
- You are going to take distributions over time (equal and periodic distributions) in 5 years and you will be over 59 ½ when completed.
- When buying a first home, you can withdraw up to $10,000 from your IRA, SEP or Simple IRA, but the penalty is not waived for Qualified Plans like the 401K or 403b.
- If the IRS attaches a lien and takes the funds, they do not charge the 10% penalty. The IRS is one of the only agencies that can attach a lien or take your retirement funds.
- If you are under the age of 65 and need money to pay for medical expenses and the amount of unreimbursed expenses is greater than 10% of your adjusted gross income.
- If you are unemployed and pay your health insurance premiums from your IRA. However, the exception does not qualify if you take it from a Qualified Plan like a 401K or 403b.
- If you are a military reservist called to active duty.
- Returned IRA contributions are an exception if withdrawn by the extended due date of the tax return, but be careful since earnings on returned contributions are not covered in the exception.
- Retirement plan rollovers or eligible distributions contributed to another retirement plan or IRA within 60 days. This exception created confusion a few years ago due to an IRS clarification. (Remember, the early withdrawal penalty is different than the distribution. If the distribution is rolled over to another qualified plan or IRA directly between custodians, it is considered a transfer. If a check was made out to you and you deposited it into your bank account and rewrote a check to your IRA custodian (a method you can only use once a year), you need to complete the transaction within 60 days of the original distribution or else it is considered a distribution and subject to the distribution rules. My suggestion is be careful and try when possible to do a rollover to another account using the custodian-to-custodian transfer paperwork. If you get a check, make sure it is made out to the custodian for the benefit (FBO) of your name. Either way, keep documentation and receipts and tell your tax advisor the entire story.
- A new exception for the early withdrawal penalty is for qualified public safety employees who are age 55 in a governmental defined benefit plan (pension) or age 50 and older. Qualified employees include specified federal law enforcement officers, customs and border protection officers, federal firefighters and air traffic controllers. Distributions from defined contribution plans or defined benefit plans (pensions) or other types of governmental plans, like the TSP, are now allowed.
- For ESOPs (Employer Stock Option Plans), the dividend passing through distributions will not be taxed the additional 10% early distribution penalty.
How to Avoid Unnecessary Penalties
Keep in mind, exceptions are closely watched by the IRS and strictly enforced. Most of the exceptions to the 10% early withdrawal penalty are outlined in the IRS code. The language is pretty straightforward, but I always recommend discussing any withdrawal or distribution plans with your tax advisor or contacting the IRS for clarification, before making a withdrawal so you understand the full tax ramifications. Definitions are very specific and mistakes can be expensive, so I strongly suggest input and knowledge by an expert as the best course of action. (Disclosure: I am a Certified Financial Planner, not a Certified Public Accountant or Tax Advisor.)
Though we are only discussing the federal tax consequences, don’t forget your state or city taxes, if applicable. Laws can vary from state to state.
To help protect you from needing to take an early withdrawal, consider setting up an adequate emergency fund. An appropriate emergency fund should have enough liquid money available to get you over a few of life’s speed bumps in order to help you avoid withdrawing from your retirement plan or other long-term investments. You can monitor your financial goals like building good credit on Credit.com.
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