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One of the questions my clients most frequently ask is “is there any way I can take money out of my retirement plan without being taxed?” The short answer is no.
There may be exceptions for after-tax contributions and your company may permit loans against the funds, but put simply, if money goes into a plan before being taxed, distributions come out taxable as ordinary income.
There are many retirement plans. Some plans are sponsored by an employer, for example: 401K, 403b, defined benefit (pension), SEP (Simplified Employee Pension), Simple IRA, SARSEP (Salary Reduction Simplified Employee Pension) to name a few.
Some plans can be taken out directly by an individual. These include a traditional IRA, Roth IRA and Solo 401K.
Generally, the amount an individual withdraws from an IRA or retirement plan before reaching age 59 ½ are called ”early” or ”premature” distributions. Individuals must pay an additional 10% early withdrawal tax penalty unless an exception applies (more about this below). The early withdrawal penalty is in addition to the tax due on the amount of the money withdrawn.
A 457b plan, (deferred compensation plan) is not subject to the 10% penalty unless distributions are attributable to rollovers from another type of plan or IRA. Simple IRA distributions incur a 25% additional tax instead of 10% if made within the first 2 years of participation.
A distribution made by someone older than 59 ½ does not incur the early withdrawal penalty as outlined in the IRS code. However, the total amount withdrawn from your retirement account will be taxed as ordinary income. For example, if you are over 59 ½ and have $30,000 of income from a part-time job and/or investments and you take a $10,000 distribution from your IRA, your total taxable income before deductions or exemptions is $40,000. If you are under 59 ½, your early withdrawal penalty would be 10% of the $10,000 withdrawal or an additional $1,000. So, you pay tax on the withdrawn amount ($10,000), plus an early withdrawal penalty ($1,000).
Confusion regarding taxation might arise when people mistake the withdrawal amount (distribution) with the early distribution penalty. They are two very different components of the tax code and withdrawal process.
Here is a rundown of when your withdrawal may generally be exempt from the 10% penalty.
Keep in mind, exceptions are closely watched by the IRS and strictly enforced. Most of the exceptions to the 10% early withdrawal penalty are outlined in the IRS code. The language is pretty straightforward, but I always recommend discussing any withdrawal or distribution plans with your tax advisor or contacting the IRS for clarification, before making a withdrawal so you understand the full tax ramifications. Definitions are very specific and mistakes can be expensive, so I strongly suggest input and knowledge by an expert as the best course of action. (Disclosure: I am a Certified Financial Planner, not a Certified Public Accountant or Tax Advisor.)
Though we are only discussing the federal tax consequences, don’t forget your state or city taxes, if applicable. Laws can vary from state to state.
To help protect you from needing to take an early withdrawal, consider setting up an adequate emergency fund. An appropriate emergency fund should have enough liquid money available to get you over a few of life’s speed bumps in order to help you avoid withdrawing from your retirement plan or other long-term investments. You can monitor your financial goals like building good credit on Credit.com.
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