Placing money into any type of retirement account is a smart financial decision—both for your future financial security and for immediate or future tax benefits. However, once you place money into these accounts, the funds are expected to stay there until you reach retirement age, which the IRS defines as 59 ½. What happens if you need the money before then? Are there consequences for early withdrawals? Here’s what you need to know about early withdrawal penalties and their impact on your taxes.
ARE EARLY WITHDRAWALS TAXED DIFFERENTLY?
Different retirement accounts are taxed differently when you withdraw your funds from them. For example, when you make a deposit into a Roth IRA account, you can deduct that amount from that year’s taxes for an immediate tax benefit; then, when you make a withdrawal from that account during your retirement, you’ll be taxed based on your current tax bracket. Traditional IRAs are taxed in exactly the opposite; you don’t get a deduction for contributions, but you aren’t taxed when you make a withdrawal. Make sure you understand those differences in taxation, both when making contributions and when making early withdrawals. In terms of taxation on early withdrawals, the taxes on your early withdrawals are no different than if you withdrew from those accounts after reaching retirement age.
ARE THERE ADDITIONAL FEES?
Though the taxes on your withdrawals are technically no different if you take them before reaching retirement age, the IRS does apply an early withdrawal penalty for funds taken out of certain accounts before you reach the age of 59 ½. Any early withdrawals from a taxable account, such as a Roth IRA, will receive an additional 10% penalty. However, this penalty is not applied to nontaxable withdrawals.
CAN THE PENALTY BE WAIVED?
There are certain situations in which you can withdraw from a taxable retirement account and not receive the 10% additional penalty. Here are a few examples of situations in which you can withdraw from your retirement account without paying the early withdrawal fee:
- The account owner becomes totally and permanently disabled.
- You are purchasing your first home (up to $10,000 can be withdrawn from certain retirement accounts).
- The account owner passes away.
- The account owner is a military reservist called to active duty (only certain distributions).
- You had excess contributions to a 401k, and are receiving corrective distributions.
If you find yourself in a situation where you need to withdraw from retirement accounts, we strongly encourage you to reach out to our tax accountants in Provo to discuss whether or not the early withdrawal penalty can be waived for your circumstances.
HOW TO REPORT EARLY WITHDRAWALS ON TAXES
If you do take an early withdrawal, how do you report this on your tax return? Any distribution or withdrawal from a retirement is considered a source of income, and should be reported using Form 5329. Many people mistakenly view these withdrawals as being similar to withdrawing from a bank account, and will overlook this income source on their taxes. However, all retirement account distributions must be reported to the IRS.
If you have any questions about how your retirement account contributions or withdrawals, contact The Accounting Guys to speak to one of our tax accountants in Provo. We can advise you on how to utilize your retirement accounts to minimize your tax liability while saving and planning for your financial future.