Here's one scenario, emailed to me by an About.com reader,
"I am thinking about taking an early withdrawal from my traditional IRA account to pay an outstanding Credit Card bill (due to car repairs). I'd like to buy a home in the near future and having this outstanding bill is impacting my credit rating. I currently pay the bill on time, have never been late, but I just want to get rid of the debt.To figure out the tax cost of withdrawing money from a retirement plan, you'll need to know:
"I am trying to figure out if the cost in what I'd pay in taxes for the early distribution is less than the cost of paying the minimum on the CC every month. The APR on the credit card is 10%.
"Can you help me figure this out, and tell me if there are other factors that I have not considered."
- Your age when the distribution was made,
- What type of retirement plan you have,
- How much you plan to withdraw,
- What the money will be used for, and
- What tax bracket you will likely be in.
Early distribution penalties will apply if you withdraw money from a retirement plan before you reach age 59.5 years old. The penalty is 10% in addition to any taxes owed on the withdrawal. The penalty increases to 25% if you are withdrawing the funds from a SIMPLE IRA and you began participating in that SIMPLE IRA within the past two year. If you are close to age fifty-nine-and-a-half, you may want to wait before withdrawing the money so you can avoid this penalty.
There are important exceptions to the penalty. If you withdraw the money to purchase a house or pay for medical expenses, the penalty may not apply. But the allowable exceptions differ by the type of retirement plan. For IRAs, there's no penalty for first-time home buyers, for unemployed persons using the money to pay for health insurance, for college tuition or high medical expenses. By contrast, distributions from a 401(k) or 403(b) retirement plan have fewer exceptions: if you are over 55 years old and are retired or left your job, to pay for high medical bills, or as part of a divorce settlement.
Once you've figured out the penalties, you'll next want to figure out how much tax will be due. Distributions from a retirement plan are taxed as ordinary income. That means, they are taxed at your marginal tax rate. Making a large withdrawal from a retirement plan can even cause you to move up to a higher tax bracket, so you'll want to pay attention to the income ranges for different tax brackets.
To get a quick estimate of your tax liability, multiply the amount you plan to withdraw from the plan, times your marginal tax bracket. And then add in any penalty. The total will be how much federal tax will be owed on the withdrawal. You should also estimate any state taxes as well.
The reader with the above scenario did not provide any information about her income or tax situation. So let's make up some numbers for her, just to see how the math works. Let's say she qualifies for the head of household filing status, is age 35 when she withdraws the funds, and her taxable income (after the standard deduction and personal exemptions) is $50,000. This would put her in the 25% tax bracket. If she withdraws $10,000 to pay for car repairs, she'll still be within the 25% tax bracket. So her federal tax impact would be $10,000 x (25% + 10%), or $3,500. She's subject to the 10% penalty because paying for car repairs isn't on the list of penalty exceptions. She'll also be on the hook for state income taxes, and possibly state penalties.
This $3,500 in extra federal taxes is the cost of tapping into these funds now. What other alternatives does she have? She could continue to pay interest on the credit card balance. This reader's credit card comes with a 10% annual percentage rate. That means over the course of a year, on a $10,000 balance, she'll rack up interest of $1,000 per year. (Assuming that the balance remains even over the course of the year.) Using a minimum credit card payoff calculator, and making the further assumption that the credit card requires a minimum payment of 2.5% of the balance per month, our reader would pay $4,888.25 in interest over 20 years to pay off the car repairs.
So what's the better deal: pay $3,500 now, or $4,888 over 20 years? The answer, I think, lies in trying to pay off the credit card bill over time. Incurring a large tax bill should be avoided if at all possible. The credit card can be paid off over time, and it can be paid off faster when there's more money available, and paid off less slowly when finances are tighter.
What other options are there? For employees, many 401(k) and 403(b) plans offer loans. Such loans can help an employee meet short-term financial hardships while avoiding the hefty tax and penalties associated with a withdrawal. (By law, loans are not permitted against IRAs.) The options would be to shop around for a lower interest rate loan, trying to earn extra income, or by creating a budget to handle the new financial situation.
I'd leave the retirement funds for when they are most needed: after reaching age 59.5, if the taxpayer becomes disabled, or when facing other situations for which a penalty exception applies.