Taxing Access to Retirement Funds – Penalties, Exceptions, and IRS Rules

Taxing Access to Retirement Funds – Penalties, Exceptions, and IRS Rules

If you withdraw funds from your 401(k), traditional IRA or 403(b) plan before the age of 59 and 1/2, you will be charged with a 10% early distribution penalty and if you withdraw money from a Simple IRA that you started contributing to only 2 years ago, the early distribution penalty is increased from 10% to 25%; however there are always exceptions to this rule. Also, this rule does not apply to Roth IRA; you can withdraw as much of what you have contributed to your Roth IRA as long as your plan has been in existence for at least 5 years. Thus if you withdraw $5000 from your 401k plan at the age of 45, you will have to pay a $500 penalty and the $5000 will be included in your taxable income when you file taxes. Therefore, it is essential to know the rules & exceptions you have to work your way around this without facing an early distribution penalty. You cannot however prevent the $5000 withdrawal from being included in your taxable income during tax time, unfortunately!

Exceptions for Early Withdrawals from Traditional IRA

  1. If the IRS levies your IRA for any tax debts you owe
  2. If you paid for medical expenses exceeding 7.5% of your adjusted gross income
  3. If you buy a house (you must NOT have owned a home in the past 2 years and there is a maximum limit of $10,000)
  4. If you pay for college fees for yourself or dependents (higher education expenses)
  5. If you were unemployed and paid for health insurance premiums
  6. If you are permanently disabled or injured
  7. If you received a lump sum payment but rolled the money over to a qualified retirement plan such as a Roth IRA within 60 days
  8. If you had a direct rollover to a new retirement account

Hardship Withdrawals The Internal Revenue Service (IRS) allows 401k investors to take out 401k hardship withdrawals in the form of loans only if these 6 criteria are met:

  1. 1. the withdrawal is due to an immediate and important financial need
  2. 2. the withdrawal must be necessary to satisfy that need
  3. 3. You have no other way to fulfill that need or no other sources of money
  4. 4. the withdrawal should not exceed the total amount needed by you
  5. 5. You cannot contribute to your 401k plan for up to 6 months after your withdrawal date
  6. 6. You must have first received all non-taxable distributions or loans available under your 401k

The following are reasons acceptable by the IRS for a hardship withdrawal

  1. 1. Repairs of primary residences
  2. 2. Funeral expenses
  3. 3. Payments necessary to prevent you from being forced out of your home
  4. 4. Home foreclosures 
  5. 5. Payments of college tuition & other educational costs such as room & board, transportation, food, etc.
  6. 6. Purchase of principal residence
  7. 7. Unexpected or un-reimbursed medical expenses

401k hardship withdrawals are subject to a 10% early withdrawal penalty as well as income taxes due. For example if you withdraw $10,000 as hardship withdrawal, you will owe $1000 in penalty, as well as be taxed on the $9000. There are some hardship withdrawals however that are not subject to the 10% penalty, they are:

  1. You stop working, get laid off, quit or retire in the year you turn 55 or after
  2. Court orders you to give money to a divorced spouse or dependent
  3. Unexpected medical debts that exceed 7.5% of your Adjusted Gross Income
  4. Permanent disabilities
  5. You stop working and begin taking regular payments based on a schedule that will make equal payments for the rest of your expected life; this must last for 5 years or until you turn 59 and 1/2, whichever is longer.
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