Need to fund an emergency cash need or pave the road to an early retirement? It’s easy to miss important considerations when it comes to early retirement distributions. In this article, we will cover the tax implications of early retirement distributions, the difference between Traditional IRA and Roth IRA distributions, and the exceptions to early withdrawal penalties.
Traditional IRAs vs. Roth IRAs
One of the most important considerations when it comes to early retirement distributions is your type of retirement account. Traditional IRAs are funded with pre-tax dollars, meaning the contributions you make to these accounts reduce your taxable income. When you withdraw the funds, they are taxed as ordinary income. On top of the income tax hit, if you withdraw the funds before age 59 ½, you could also be subject to the 10% early withdrawal penalty.
On the other hand, Roth IRAs are funded with after-tax dollars. This means that you have already paid taxes on the contributions you make to these accounts. When you withdraw the funds, qualified withdrawals are tax-free. However, if you withdraw the funds before age 59 ½ and you have not held the account for at least five years, you may be subject to taxes and penalties on the earnings portion of the withdrawal. (The “five year rule” is complex, so please review before considering a withdrawal.)
Exceptions to Early Withdrawal Penalties
While the 10% early withdrawal penalty applies to many early withdrawals from Traditional IRAs, there are exceptions to this rule. For a complete list of exceptions, please be sure to visit the IRS Retirement Topics for more information. Here are the top five exceptions to the 10% early withdrawal penalty.
- First-time homebuyer expenses: You may be able to withdraw up to $10,000 from your Traditional IRA if the funds are used to pay for the purchase of your first home.
- Higher education expenses: You may be able to withdraw funds from your Traditional IRA if the funds are used to pay for higher education expenses, such as tuition, fees and books.
- Medical expenses: You may be able to withdraw funds from your Traditional IRA if the funds are used to pay for medical expenses that are not covered by insurance (but only if medical expenses exceed 7.5% of your adjusted gross income).
- Disability: If you become permanently disabled, you may be able to withdraw funds from your Traditional IRA.
- Death: If you die before age 59 ½, your beneficiaries may be able to withdraw funds from your Traditional IRA.
Tips for Avoiding Common Mistakes
One of the biggest mistakes taxpayers make when it comes to early retirement distributions is failing to set aside enough money to pay the tax liability on a Traditional IRA withdrawal. IRA custodians often don’t suggest a high enough withholding rate. This can lead to a large tax bill at return time. You should understand your marginal tax rate (the tax rate that applies to the next $1 of income that you earn). Add your marginal tax rate to the 10% early withdrawal penalty to determine the total tax implication of the withdrawal. Save accordingly.
Another common mistake is failing to consider the long-term impact of early withdrawals on your retirement savings. Withdrawing funds from retirement accounts too soon can greatly reduce the amount of money you have available in the future. It can also increase your tax liability. To avoid these mistakes, it’s important to create a retirement plan that takes into account goals, timeline and expected expenses. You should regularly review and update this plan as needed.
Early retirement distributions can have significant tax implications that are often overlooked by taxpayers. By understanding the difference between Traditional IRAs and Roth IRAs and the exceptions to early withdrawal penalties, you can reduce your tax bill and surprises at tax time.