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Taking Early Withdrawals from Retirement: How Will it Affect My Taxes?

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We all look forward to the day when we can retire from our career and finally start to enjoy life without worrying about work. Retirement accounts are established to put money away for this special time. It helps you cover not only basic living expenses once you retire, but also special vacations and trips.

Even though the funds in a retirement account belong to you, the IRS does charge a penalty if you withdraw the money too soon. If the funds are withdrawn before you reach a certain age, the funds must be included as part of your taxable income—and can also be subjected to an additional penalty that is sometimes as high as 25 percent.

Therefore, it is important that you understand the penalties associated with taking early withdrawals. In many cases, it is not worth it unless you desperately need the money.

Qualified Retirement Plans 

Retirement plans are different from Social Security, which is a right granted to everyone. Not everybody has a retirement plan. They are usually offered as a benefit to a job, though some open up their own account on the side.

Plans that are subjected to taxable income and tax penalties if you withdraw too soon include the following:

One should note that state or local 457 government plans are not part of the qualified retirement plans that are subject to a federal tax penalty. While there could be some state penalties, early distributions are usually not penalized in the same way.

Early Withdrawals and Distributions 

Qualified retirement plans are reserved for when you reach the point in your life where you are ready to retire. They are not intended as quick sources of income when you may need some extra cash.

As a result, whenever an early withdrawal or distribution is made to a qualified plan, that amount is added to your gross income for the year. Since the funds become part of your gross income, they are also now taxable.

In addition to having a higher taxable income because of the early withdrawal, you will also have to pay a penalty. This penalty varies based on several factors—and can be as high as 25 percent of the funds that were withdrawn.

How do you know if you are making an early withdrawal? Your retirement plan should have terms and conditions that make it clear. A common age for plans is 59 ½. Any distribution before that age is considered an early withdrawal and will be heavily taxed for taking the money out prematurely.

The Penalty Tax 

In addition to your distribution(s) becoming taxable income, the penalty tax is a heavy burden for people with retirement plans that need the money sooner than the conditions of the account. Here are a few other key details about this tax:

Exceptions to the IRS Penalty 

The good news is that there are some exceptions that can prevent your funds from becoming taxable and subject to early distribution penalties. You may not be penalized if any of the following circumstances are true:

Exceptions for 401(k)s and 403(b)s 

There are additional exceptions for 401(k) and 403(b) accounts:

Getting Tax Help for Retirement

Retirement can be complicated. In order to correctly manage your funds and avoid giving the government more than you need to, check with a tax professional to make sure the distribution is not considered an early withdrawal.

Levy & Associates offers free initial consultations. Contact us at 800-TAX-LEVY, or visit www.levytaxhelp.com for more details.

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