Penalties for Deducting from Retirement

401(k)s have become the majority of retirement savings for many people today as the era of defined-benefit pensions is trickling to a close. With the economic downturn and the lingering recession, many people have tapped into their 401(k)s as a source of money. This is obviously not an ideal situation, but one that is, unfortunately, necessary for many people out there right now. Let’s look at the main drawbacks to touching this money before rules permit.

1. The investment is no longer growing – Withdrawing this money means that the investment no longer accumulates interest and grows over time. This lost time for the money to the compound will substantially shrink your nest egg.

2. You will owe more taxes to the IRS – Early withdrawals are taxed as ordinary income. So not only is your money no longer growing at the same rate, you now have to pay taxes on money that was previously tax-sheltered.

Assessed Penalties – The IRS will assess a 10% penalty on early withdrawals. So if you withdrawal $10k, you will have to pay a penalty of $1k on your money.

Studies have shown that many people (as high as 60% in some surveys) withdraw money from their employer’s tax-sheltered retirement accounts when changing jobs, but this is clearly unwise. This money should only be pulled out prematurely as a last resort in an emergency situation.

Now I could be remiss if I didn’t mention some exceptional circumstances that are exempt from the 10% penalty levied by the IRS:

Borrowing for a loan – You can borrow up to half of your accumulated assets in an employer-sponsored account or $50k whichever is less. These loans must get repaid with after-tax monies. If you change employers during the loan repayment period, the unpaid balance becomes due within 30 days. If not repaid in this time frame, it becomes a withdrawal and taxes are assessed accordingly. You cannot borrow from IRA accounts.

Early retirement – You may be able to avoid a penalty if you are disabled or retire early and you are willing to take annual distributions according to an IRS-approved annuity schedule for a period no less than five years. You will still require paying taxes on the amount withdrawn.

Qualifying expenses for school, medical bills, or home buying – You can make a withdrawal from an IRA (not an employer-sponsored plan) without penalty in order to pay medical expenses over 7.5% of your AGI, if you pay medical insurance premiums after being on unemployment for 12 weeks, you pay for qualified high education expenses, or you take out less that $10k for qualifying first-time home buyer expenses. You will also have to pay taxes on the amount you take out.

Withdrawing early will lose you a lot of money. There is a ten percent early withdrawal fee straight off, and then there is both federal and state taxes. The state tax percentage is different in every state, and federal percentage levels vary depending on your income bracket (which may be raised this year because the money you withdraw will count as income for the year). Due to these varying factors the percentage varies from person to person but you can estimate that you will lose thirty to forty percent of the money you withdraw, as well as the money you would have earned during the time this money would have been invested until you reached retirement. This very high loss is why financial experts will advise you to find any other way to avoid withdrawing from a 401k.

There are some exceptions to these rules with some plans, so you’ll need to look over your employers options. Some will let you withdraw under special circumstances, such as economic hardship or for tuition, and some will allow 401k loans. Of course, even under these circumstances, there will still be the penalties explained above.

The penalty for withdrawing from a 401k is high and drastically reduces the amount of money you’ll have right now, as well as for your retirement.

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