September 11, 2020
By Rahul Iyer
If you are ever placed in a position where you must withdraw from your 401(k) plan or independent retirement account (IRA), you should consider the possibility of facing penalty fees. IRAs and 401(k)s are excellent retirement savings plans. Both plans are utilized by many Americans. The pre-tax benefits of these plans make them very desirable; however, they are designed to be withdrawn from later in life and not before the age of 59 ½.
The early withdrawal of funds from your 401(k) plan or your IRA is not a great idea. Both plans require that you wait until 59 ½ before making withdrawals. If you are faced with an emergency and must withdraw funds from your retirement account before arriving at the plans’ required age, you are likely to face penalties. The penalty of both 401(k) plans and IRAs is 10% of the withdrawal.
Penalty fees are not the only drawbacks to withdrawing early. Early withdrawal will make it necessary for you to pay federal income tax, which is calculated at your marginal rate. In addition to this, you will need to pay the applicable state income tax on the sum withdrawn. As you can imagine, these add up and can really eat into your retirement savings.
It is best to forget about your retirement savings account as one would a pension. It is impossible to withdraw funds from a pension; therefore, when people place their money in a pension fund, they do not consider it when an emergency comes up. On the other hand, IRAs and 401(k)s allow contributors to withdraw as they desire. Early withdrawal from your retirement savings accounts should not be done unless you have absolutely no other option.
Hardship: There are instances where you can withdraw funds early from your retirement accounts without penalty. Many 401(k) plans permit contributors to withdraw funds early due to hardship. To understand exactly what hardship means in the context of your 401(k) plan, you must consult with your plan’s administrator.
First-Time Home Purchase: If you are planning on buying a house, you can withdraw as much as $10,000 from your IRA without penalty. This only applies if you are purchasing your first home. The hardship withdrawal clause may also apply to such purchases under some 401(k) plans. Again, you should speak with your employer to find out if you can withdraw funds from your 401(k) to purchase your first home without penalties.
Unreimbursed Medical Expenses: Unreimbursed medical expenses exceeding 10% of your adjusted gross income in a particular year will make you eligible to pay from your IRA without facing penalties. In the case of a 401(k), unreimbursed medical expenses exceeding 7.5 % of your adjusted gross income for the year can be covered by a withdrawal without penalties.
There are unfortunate instances that can cause an individual to make an early withdrawal. There are many instances where you can make these withdrawals without facing a penalty. Outside of withdrawals that fit within the established terms and conditions of your 401(k) or IRA, you will face penalties and taxes that will impact your balance in a notable way. If you don’t have to, avoid making an early withdrawal from your retirement savings account.