If you take money out of a retirement account before you reach 59-1/2 years of age, you may be subject to an early withdrawal penalty of 10%. Here's how to determine whether your withdrawal will be exempt from the penalty, and if not, how much you can expect to pay.
What types of withdrawals are subject to a penalty?
Whether or not you will be assessed a penalty depends on how the money you withdrew got into your account. There are three main ways money flows into retirement accounts, and two of these can be assessed a penalty if withdrawn prematurely.
- Pre-tax contributions: this includes money that was withheld from your paycheck for your 401(k) or other employer-sponsored plan -- unless it is a Roth account -- as well as tax-deductible contributions to a traditional IRA, SIMPLE IRA, or SEP IRA. Employer matching contributions to your retirement accounts also fall into this category. Basically, if the contribution resulted in a tax deduction, or reduced your taxable income in the year you made it, it falls into this category. Pre-tax contributions will be assessed a penalty if withdrawn too early, unless an exception applies (more on the exceptions later).
- After-tax contributions: contributions to a Roth IRA, or any other Roth account such as a Roth 401(k) are made on an after-tax basis, meaning that you've already paid income taxes on the money before you put it in the account. If you had any non-deductible traditional IRA contributions, they also fall into this category. After-tax contributions can be withdrawn at any time, and for any reason, without penalty.
- Investment gains: regardless of the contribution type, investment gains (profits) in a retirement account cannot be withdrawn early without penalty. For example, if you contribute $5,000 to a Roth IRA and your account is worth $6,000 thanks to strong investment performance, you can be assessed a penalty on the $1,000 profit if you withdraw it for an unqualified purpose.
To sum it up, if you received a tax benefit on the money you're withdrawing, it can be assessed a penalty. Pre-tax contributions have obvious tax benefits, and since retirement investments are allowed to grow on a tax-free or tax-deferred basis, their profits are also considered to have tax benefits.
The early withdrawal penalty and its exceptions
In general, if you make a withdrawal from your retirement accounts before you reach age 59-1/2, the IRS will assess a 10% early withdrawal penalty. As mentioned, your original after-tax contributions to Roth accounts can be withdrawn anytime, as can any non-deductible contributions to traditional IRAs.
There are exceptions to the early withdrawal penalty, including these:
- If you are 55 or older, you can withdraw from your 401(k) or other employer-sponsored plan if you have separated from service, that is, you are no longer at your job. Note that this exception does not apply to IRAs.
- You can withdraw up to $10,000 from an IRA to be used toward a first-time home purchase for yourself or a loved one.
- You can withdraw any amount from an IRA at any time, if you use the money to pay for qualified higher education expenses.
- In a 401(k) or similar plan (but not an IRA), you can withdraw money at any time, if you agree to do so in substantially equal distributions for the rest of your expected lifetime.
- If you become totally and permanently disabled, the penalty is waived.
- Early withdrawals are allowed to pay unreimbursed medical expenses above 10% of your adjusted gross income.
Calculating your penalty for cashing out
If all of your contributions were made on a pre-tax basis, such as with a 401(k) or traditional IRA, the calculation is easy. As long as you don't qualify for an exception, your penalty is 10% of the entire amount you withdraw early.
In a Roth account, subtract your total Roth contributions from the amount of your withdrawal. If you get a negative number, you won't have to pay a penalty, as your withdrawal will be considered a return of your original contributions. If you get a positive number, you'll have to pay an amount equal to 10% of this amount.
If you have nondeductible traditional IRA contributions
Finally, if you have non-deductible contributions to a traditional IRA (this is not too common), you need to determine the portion of your account that represents those contributions. To do this, divide the amount of non-taxable contributions you've made to the account, and divide this amount by your account's current value.
To determine the pre-tax portion of the account, subtract this number from one.
Finally, use this as a multiplier to determine the amount of your withdrawal subject to a 10% penalty.
For example, let's say that you withdraw $5,000 from your traditional IRA early. If your account is worth $50,000 and you've made $10,000 in nondeductible contributions, you can determine that the nondeductible portion is 20%, or 0.2. Subtracting from one gives a pre-tax portion of 80%, or 0.8. Finally, the penalty can be calculated using this multiplier as described in the preceding equation.
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