How Does Withdrawing from Retirement Accounts Early Impact Your Taxes?
Placing money into a retirement account can have both immediate tax benefits and future financial benefits. It’s a smart move all around to be putting funds into your retirement accounts regularly. However, in some cases, you may need to withdraw money from those accounts before you retire. What happens if you withdraw from retirement accounts before you reach retirement age? Keep reading to learn more about how this situation can impact your taxes.
What’s Considered an Early Withdrawal?
First, let’s address what is legally considered an “early” withdrawal. Obviously, people can retire at different ages, so whether or not you have actually retired from your job is irrelevant as to whether or not your withdrawal from a retirement account is considered “early.” Rather, it’s based on your age. An early withdrawal refers to taking money out of a retirement plan before you’ve reached the age of 59 ½. Beyond this age, regardless of whether you’re still working or not, any withdrawals would not be considered early withdrawals.
Will That Withdrawal Be Taxed?
Different retirement accounts have different rules pertaining to whether or not withdrawals are taxed. For example, when depositing into a Roth IRA, you get a tax deduction; but when withdrawing, the money pulled from a Roth IRA will always be taxed at your current income tax bracket, regardless of whether the withdrawal is early or not. Traditional IRAs are just the opposite: You don’t get a tax break when depositing, but the withdrawals are not taxed as income.
It’s important to be aware of what the tax laws are for all of your retirement accounts, so you can properly plan for your finances. This is true in any situation where you are withdrawing funds from a retirement account—early or not.
Are There Additional Fees for Early Withdrawals?
If you withdraw early from a retirement plan, you may not only find yourself paying your basic income taxes on that withdrawal, but an additional tax as well. The IRS charges an additional 10% penalty for early withdrawals from most qualifying retirement plans. This additional tax does not apply to nontaxable withdrawals, however. A nontaxable withdrawal would include the withdrawal of any contributions that you paid tax on before placing the funds into the retirement plan.
Are There Exceptions to the Early Withdrawal Penalty?
Yes, there are actually many exceptions to that 10% additional tax, even on taxable withdrawals. A few of these exceptions include:
- Total and permanent disability of the account owner
- Qualified first-time home purchase (up to $10,000 from certain retirement accounts)
- Death of the account owner
- Certain distributions to military reservists called to active duty
- Corrective distributions of excess contributions to a 401k
If you need to make an early withdrawal from a retirement account, we strongly advise you to speak to one of our CPAs to determine if your reasons for withdrawing can qualify you for an exception from the 10% additional tax.
How Do You Report It on Your Taxes?
If you do take an early distribution, you may have to file an additional form with your federal tax return to report that source of income. The form used to report these withdrawals on your taxes is Form 5329. Unfortunately, many people overlook the importance of reporting this income on their taxes, as they view their withdrawal as being similar to withdrawing from a bank account. However, because retirement accounts often offer those tax benefits when depositing funds, withdrawals from them are handled differently, and must be reported to the IRS.
If you’ve taken or are planning to take an early withdrawal from any retirement account, contact Demian & Company CPAs today to speak to one of our tax experts. We can walk you through the pros and cons of this option and help you better understand how an early withdrawal from your retirement account will impact your taxes, as well as your financial future. Call now to schedule a consultation with one of our CPAs and get the guidance you need.