How Early 401K Withdrawals Can Affect Your Tax Return
Your 401(k) retirement account is an excellent way to save for your retirement and some employers even match your contributions, giving you an extra boost for your nest egg. But, what happens if you come upon hard times before you retire and need to cash in some or all of your 401(k)?
Accessing these funds before you are 59 and a half may help you in the short term, but keep in mind that there are tax consequences for tapping into your retirement early. You want to make sure that you take these consequences into account ahead of time so that you are not hit with a hefty tax bill come April that creates another financial problem for you and your family.
Increased Taxable Income
If you withdraw funds from your 401(k) before retirement, these funds become taxable income that’s added to your regular annual income. This is primarily because the contributions were not counted as taxable income when you put them into your retirement account. It is also possible that this additional taxable income can push you into a new tax bracket, also causing you to owe more to the IRS.
Early Withdrawal Penalties
When you take money out of your 401(k) early, you also will likely have to pay a penalty for doing so on top of paying the taxes already discussed. Most often, the penalty you’ll pay to the IRS is 10% of what you withdraw from your retirement account. So, if you take $10,000 out of your 401(k), you will have to pay the IRS an additional $1,000 for the early withdrawal penalty.
There are some exceptions to the early penalty rule that you should be aware of. In these cases, you can take out as much as you need without penalty:
- If you have a permanent physical or mental disability that a physician can sign off on and can thus no longer work, you can take IRA withdrawals without penalty.
- If you lose your job and collect unemployment compensation for 12 consecutive weeks, you can take penalty-free IRA distributions if you use the money to pay for health insurance for you or your spouse or dependents. The contingency to this is that you must collect in the year you received unemployment or the following year and before you have been employed again for 60 days or more.
- Medical expenses that exceed 10 percent of your adjusted gross income that is not reimbursed by health insurance are not subject to the early withdrawal penalty.
- Withdrawal from your 401(k) for college costs such as tuition, fees, books, supplies, and equipment or even room and board are eligible for penalty-free withdrawal. However, the institution must be able to participate in federal student aid programs and you must be at least a half time student. Just be aware that IRA distributions are considered taxable income and could reduce your eligibility for financial aid or the total you might receive.
- First home buyers can withdraw from their can cash out from their 401(k) up to $10,000 (or $20,000 for couples) without incurring the early withdrawal penalty. Stipulations include not having owned a home for the two years prior to the home purchase and if for whatever reason the purchase or construction of your home is canceled or delayed, then you must put the money back within 120 days.
- Active military personnel can take 401(k) withdrawals during a period of active duty of more than 179 days to supplement their income, then they do not have to pay a 10 percent penalty on the amount withdrawn.
- IRA cash outs taken as a series of annuity payments are not subject to the early withdrawal penalty. The payments are calculated based on your life expectancy and generally require professional assistance to calculate which you can contact us about it as the specifications can be tricky.
- If you have a Roth IRA then early withdrawal will have fewer restrictions such as being able to withdraw your contributions, but not the earnings. However, the Roth IRA must be at least five years old to not incur the early withdrawal penalty.
- In the difficult circumstance where an IRA is inherited (before age 59 ½), you can take penalty-free withdrawals but will then need to pay income tax on each distribution in that tax year. The exception to avoiding the penalty of early withdrawal of 401(k) is if you elect to treat the 401(k) as your own.
Even if you qualify for one of these exceptions and your early withdrawal penalty is waived, you will still be responsible for the additional income taxes. So keep this in mind before withdrawing from 401(k) fidelity and make plans to pay the tax.
How to Make the Best Decision About Your 401(k)?
An early withdrawal from your 401(k) can be tempting, especially if you are experiencing a difficult financial time. Calculating whether the benefits of having the money early outweigh the potential tax implications is a difficult one. If you are unsure what is in your best interest, you may want to consider seeking some help and advice on how to proceed.
Success Tax Relief specializes in giving sound, honest advice to taxpayers. We’ll help you weigh all possible pros and cons so you can make an informed decision. We can also help you plan ahead if you decide to take an early withdrawal so that there is no reason to panic come tax time!
If you have questions about an early withdrawal and want to consult a tax professional, contact us before you make a move with your 401(k).