Q: Tax Playa, what happens if I take money out of my IRA or 401(k) before I'm retired?
Tanya, Fairfax VA
A: These retirement accounts are just that--for retirement. If you take money out of them early, you generally must pay any tax due plus a 10% penalty. There are some exceptions, though, that differ based on the type of account you have.
The rules are very different for the various tax-advantaged savings vehicles. One common rule is that you are allowed to take money out for 60 days and put it back in without a tax consequence. This is known as a rollover.
Let's break the accounts into several categories:
1. Coverdell Education Savings Accounts and 529 College Savings Plans. These plans have after-tax money going in, so any tax paid on a non-education withdrawal is only on earnings. Additionally, there is a 10% penalty on these earnings.
2. Health Savings Accounts. Contributions to these accounts are tax-deductible. Therefore, non-health withdrawals are subject 100% to tax (since there is no basis in the contribution). Additionally, there is a 10% penalty on the entire distribution.
3. Traditional IRAs. Contributions to these accounts are tax-deductible. Therefore, pre-retirement (age 59 and 1/2) withdrawals are subject to taxation (since there is no basis in the contribution). Additionally, there is a 10% penalty on the entire distribution.
Exceptions to the 10% penalty (though not the tax) on early withdrawals are:
- Unreimbursed medical expenses totaling more than 7.5% of AGI
- Distribution not more than medical insurance and you are receiving unemployment
- Beneficiaries of the deceased IRA owner
- Distribution received in the form of an annuity
- Distribution not more than qualified higher education expenses
- $10,000 used to buy, build, or rebuild a first home
- Active duty military reservists called up for more than 180 days
- Distribution due to IRS levy
4. Roth IRAs. Contributions to these accounts are after-tax. Therefore, pre-retirement (age 59 and 1/2) earnings are subject to taxation (not the amount contributed, since that is after-tax). Additionally, there is a 10% penalty on these withdrawn earnings.
Exceptions to the 10% penalty are the same as those listed above for Traditional IRAs.
Any basis in Roth conversions takes 5 years to accumulate for the purposes of the penalty and taxes.
5. Defined Contribution Pensions (401(k)s, SEP-IRAs, etc.) Contributions to these accounts are normally pre-tax (with the exception of Roth 401(k) deferrals). Therefore, the taxablity of the distribution is similar to that of Traditional IRAs above. There is also a 10% penalty for pre-retirement distributions.
Exceptions to this 10% include:
- Substantially equal periodic payments
- Made after separation from service if over age 55
- Made under a qualfied domestic relations order
- For medical expenses over 7.5% of AGI
- Reducing excess deferrals and employer contributions
- IRS levy on the plan
- Distributions to first responders