Risks and Benefits of Early Retirement Plan Withdrawal
Exceptions to Penalties
The Internal Revenue Service allows taxpayers to withdraw cash without paying a penalty under certain circumstances. If you use money to purchase your first home, send someone to college or pay medical bills above 10 percent, you may withdraw cash without paying an extra 10 percent to the IRS. Someone who becomes permanently and totally disabled also receives retirement savings benefits without paying penalties.
Upon the death of an account holder, beneficiaries do not pay penalties. These benefits reduce the income tax paid, but they also reduce the money you have saved for retirement that earns interest.
Loans Against Retirement
Companies that administer retirement accounts may loan money against the value of your retirement savings. This gives you access to cash without withdrawing from the actual retirement account. However, the loan interest repayment may hinder the amount put into a qualified retirement savings account. This plan may also liquidate some of the account if you cannot pay off the loan.
Income Taxes Owed
Taxpayers owe regular income taxes on any withdrawals, no matter when those happen. You must make up the difference after the federal government takes a cut. Administrators typically leave 20 percent in the account to pay income taxes, so if your account has $10,000, you only have access to $8,000. When you are in higher income tax brackets, you might owe more income taxes than 20 percent, and an early withdrawal assesses an extra 10 percent penalty. For a $10,000 payout in the 25 percent bracket, with a 10 percent penalty, you only get to keep $6,500.
Withdrawing early means you can still earn income to replace that money. However, you have to make double payments to make up for lost payments until you replenish the amount you withdraw early. If you cannot replace the withdrawal amount, you have less cash invested in the account to earn interest and fewer overall disbursements for retirement when you stop working. When you earn less money for retirement, you must scale back your plans and live more frugally.
Withdrawing money early from a retirement plan has a few advantages, but also has several disadvantages. The consensus among financial planners remains that people should leave money in retirement accounts as long as possible. However, life happens before you turn 59 1/2 years old, and you may have to pay penalties for early withdrawals. Consider the risks and rewards of getting cash out of your qualified retirement accounts early with this handy guide.
More prudent strategies include setting aside cash in a separate savings account for emergencies or finding ways to earn more income, rather than withdrawing from a retirement account. Discuss options with your financial planner or accountant to determine how best to proceed when you need extra money.