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William Perez

Deciding to Withdraw Money from a Retirement Plan

By July 10, 2008

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When finances get tight, people think about tapping their retirement savings. Sometimes withdrawing money from a tax-deferred retirement plan can prevent a financial disaster. But taking an early distribution comes with stiff taxes and penalties. Figuring out if cashing out your retirement plan will help involves comparing taxes and penalties owed on a retirement distribution to other financing options.

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.

"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."

To figure out the tax cost of withdrawing money from a retirement plan, you'll need to know:
  • 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.

Comments
April 5, 2010 at 8:15 pm
(1) Marty McQuade says:

I read about the early distribution of IRA account and its penalities. Another one I read on the impact of early withdrawal/distributions from a retirement plan. It says the penalities are higher if you withdraw around age 59. What about if you are in the 62/63 age category? I am thinking of withdrawing only what I need to pay off all my aged debts; student loans, 8-year credit card, and all the little ugly stuff. Hope to hear from you soon. Marty

April 19, 2011 at 11:36 am
(2) Mike says:

William,
I was lwondering what will happens for my retirement savings if I leave US for good and go back to the country I was born (in the Middle East). Can I withdraw my retirement saving and take it with me, how much the charge would be? is it considered an acceptable reason or I will have the penalty anyways. I am in 25% tax bracket. I am currently 33 and am not sure how long I will stay in US ; was wondering how much to contribute in the retirement plan since my company also matches 50% and will match 100% next year, that encourages me to contribute more, however I don’t know what will happen at the end say 5-10 years from now.
Thanks,
Mike

July 4, 2011 at 8:45 am
(3) Len says:

Is the impact only 10% if you’re unemployed and not making any income? Can part of the with drawl be off set by standard and itemized deductions? I’m 40, was very fortunate to make good money over the last 10 years. I have not been able to get back to work but have approximately $400K in retirement funds. I have no debt other than my current mortgage. I have some positive equity but not a ton. My wife and I are thinking about selling our big house and downsizing and buying a home cash. Does this make sense to anyone?

September 12, 2012 at 12:43 pm
(4) ready to die says:

If I have myself killed will my family be able to use my retirement?

May 17, 2013 at 7:48 pm
(5) Barbara says:

My husband and I are 68 years old and have decided to purchase a home for $135,000 in Texas. I am taking the money out of my IRA and was wondering how much taxes I would owe. Our only income is our Social Security monthly benefits and my husband has a very small pension, about $283 per month. I retired in 2011 and my husband retired in 2010. We currently live in NJ and are in the process of selling our home there. However, we do not need to sell that house in order to buy the house in Texas and we committed to buy the new house.

Thank you.

May 18, 2013 at 3:27 pm
(6) Ray says:

William,
I’m eligible to retire now, I have been contributing to a municipal employees pension plan at my job in Houston Tx. for several years now. I am debating on whether to enter the Drop Plan (Deferred Retirement Option Plan), for three years and earn money on it and keep working, or just get my retirement money sent to me. I am low-income (27,000) and get earned income credit, child tax credit, and several other credits on my income tax. I’m afraid that when I withdraw my money after the three years I will have to pay taxes on that, and wont qualify for any credits, because of the investment into the drop plan.

Thank you,

June 29, 2013 at 2:51 pm
(7) jim anderson says:

I am unemployed, owe 4+ months of back child support (about 2000.00), one month behind on my (8.1 % ARM loan) mortgage payment with this month now owing (1,200.00 for this), owe 990.00 for a class from last semester and need 3,000.00 for this fall semester to finish my M.A. in Teaching English for an essentially guaranteed job and humble career teaching English. I think that I may qualify for avoiding negative fees were I to cash out my PERSI retirement fund of just over 30,000.00 by using it to pay college tuition and my house, which is my first house purchase of about 12 years ago. And with my house mostly paid off and with a 24,000.00 per year job teaching English I might be able to re-fund my retirement over the remainder of my life. I am just over 30 years old. Is this a good idea? Under what circumstances is it ‘sensible’ to wipe out one’s retirement fund? Is child support a fee-exemption expense when cashing out one’s persi fund ?

March 13, 2014 at 10:06 pm
(8) Edie says:

Inam 59 1/2 I have about 200,000.00 ina 401k
? I was considering drawing about 50,000.00 to pay off somedebt. What would I owe in taxxes??

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