When Your Budget Doesn't Cut It: Early Withdrawals from Retirement Savings Plans

When Your Budget Doesn't Cut It: Early Withdrawals from Retirement Savings Plans

withdrawals from retirement savings plans

Congress created tax laws for retirement savings plans that both encourage savings and punish early withdrawals. The rules extend to many types of accounts, including traditional individual retirement accounts, 401(k) plans and Roth-style arrangements. However, life is sometimes not so tidy, and budgets, no matter how meticulously planned, may be too aggressive, can become obsolete or overwhelmed by unplanned events.

Age Limits

Many retirement plans penalize early withdrawals -- money you remove before reaching some set age, such as 59 1/2. For example, traditional IRAs charge a 10 percent penalty on early withdrawals on top of the normal taxes you pay for all withdrawals. Another example, Roth-style IRAs, allow you to siphon off money you've contributed at any time. However, early Roth distributions of earnings are subject to taxes and penalties. Other types of retirement plans, such as 401(k), 403(b) and 457(b) arrangements, have their own specific rules regarding early withdrawals. Always check with your plan administrator for the rules that apply to your specific plan and, if you are uncertain, verify the information with a representative from the Internal Revenue Service.

Penalty Exemptions

Your retirement account may allow early withdrawals for prescribed reasons. For example, the IRS will not penalize early IRA withdrawals resulting from certain planned and unplanned needs. These include early withdrawals for education, home purchase, disability, and other unforeseen expenses. Once again, the exact rules depend on the type of plan and you should not generalize IRA rules to non-IRA plans without first checking with your plan administrator and any written documentation about the plan. When making an early withdrawal, it makes sense to figure the net amount of money you will receive after accounting for any taxes or penalties that might apply.

Verify Distribution Information

If your withdrawal qualifies for an exemption, be sure to marshal proper documentation and check to make sure that the exemption has been granted. If you receive a copy of IRS Form 1099-R, "Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.," verify that the distribution code is correct -- an incorrect code might cause you pay taxes or penalties improperly. The IRS publishes an instruction booklet for Form 1099-R that explains the codes used on the form. If you receive an improperly coded 1099-R or similar form, contact your trustee or administrator and have it issue a corrected form. You generally must file IRS Form 5329 to report additional taxes on early withdrawals from a qualified retirement arrangement -- that is, a plan that receives tax benefits.

Alternatives

If you can find an alternative to an early withdrawal from a retirement plan, you might be able to meet your immediate needs for cash without jeopardizing your retirement income. To help meet emergency needs for cash, you might want to set up a special savings fund just for this purpose. Some plans might have helpful provisions. For example, your plan might allow you to borrow against it -- check with your administrator to see if this option is available. If you own a home, you might be able to arrange a revolving equity loan with your bank that will help you weather a financial storm. As Ren J. Carlton, CPA, observes about taking out money before retirement: "It is almost never a good idea, especially in your younger years. It might compromise your ability to retire in the future. If possible, you should try to borrow money or sell off an asset rather than tap into your retirement funds. Perhaps your employer will lend you money or give you a cash advance. Also, you might seek guidance from a qualified financial adviser who can help you create or update a budget and check whether you qualify for government assistance."

Finally, if you repeatedly need to prematurely tap into your retirement plan for an extended period of time, check with your administrator to see whether your specific plan offers a penalty-free distribution arrangement, such as the "substantially equal periodic payments" available for IRAs.

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