Taxes May Outweigh The Benefits For Early Distribution From Your Retirement Accounts

Clearly after experiencing the job losses and other turmoil that will make 2008-2010 forever memorable, many Americans have been feeling immense financial pressure. During these times, when families really need additional money to meet their needs, a retirement account may seem like a convenient resource to tap. The tax hit from taking an early distribution from your tax-deferred retirement plan could be considerable enough to make you think twice.

Look out for those taxes.If you are younger tha
59½, working, and you withdraw funds from your 401(k) or IRA just as you would from a bank account, you might really feel the pain next April. An early distribution from an IRA or a qualified retirement plan must usually be included in your taxable income for that tax year. So the distribution you get this year will show up next year when it's time to file your tax return. Remember, because you are withdrawing money from a tax deferred retirement plan, all of the money will need to be added to your taxable federal income for the year in which you take the distribution. This could add significantly to your tax liability especially if you do not have taxes withheld when you request the distribution (many people overlook this). If you take an early distribution from a Roth IRA, you won't be taxed on the amount of your contributions. Any amount above that which is attributable to the Roth IRA's earnings will be subject to tax.1

A 10% tax penalty may also apply.To help encourage saving for retirement by younger workers, the federal government really tries to discourage people from raiding their traditional IRAs, 401(k)s and 403(b)s before reaching retirement age. So, this additional 10% early withdrawal penalty is in place to further limit premature distributions.1

There are a few exceptions to this rule. The 10% penalty may not apply if you are using the money you withdraw for:

Deductible medical expenses (documented medical expenses that exceed 7.5% of your adjusted gross income).
Higher education expenses (for you, your spouse, or children or grandchildren either of you may have).
The purchase of your first home, or the building or rebuilding of a first home.2,3
You are also exempt from the 10% penalty on premature distributions if you are "totally and permanently" disabled, in the words of IRS Publicatio
575.2

Another notable exception: the 10% penalty on early distributions does not apply if you are the beneficiary of a deceased IRA owner. If a traditional IRA owner dies before age 59½, neither the owner's estate nor the beneficiary will face the 10% early distribution penalty when those IRA assets are distributed. However, if your spouse dies and you decide to treat an IRA you inherit from him or her as your own, any distribution you take from it before your reach age 59½ may be subject to the 10% penalty.3

Is this the best decision?An early distribution from an IRA or a qualified retirement plan may turn-out to be more costly than expected. It also reduces the invested assets within that retirement account - assets that will definitely be needed in the future to provide for your needs when you are no longer willing and able to work. Ultimately, if you need to meet needs today, you may have to look at sacrificing tomorrow; however make sure to review all your options and...

This is why your accountant, tax preparer, and/or financial advisor likely warn their clients against making such a move. Sometimes in a pinch families feel they have no choice except to make a withdrawal from their retirement savings; I suggest you consult with your trusted tax
advisor(s) to let them know before finalizing the decision.
Citations

1 - advisorone.com/article/irs-top-10-tax-facts-about-early-distributions-retirement-plans [3/2/11]

2 - irs.gov/pub/irs-pdf/p575.pdf [2010]

2 - irs.gov/pub/irs-pdf/p575.pdf [2010]

3 - irs.gov/pub/irs-pdf/p590.pdf [2010]

3 - irs.gov/pub/irs-pdf/p590.pdf [2010]