Retirement will likely be your most expensive financial goal, and you spend your entire working life prepaying for it. Luckily, the U.S. government gives Americans some major incentives to save in the form of tax-advantaged retirement accounts. But you need to follow the rules if you want to enjoy the tax savings these accounts offer.
When you save in a tax-deferred retirement account, unless it's a Roth-type account, your distributions will be subject to income taxes at some point. But if you make withdrawals at the wrong time, you may be subject to penalties in addition to whatever income taxes you may owe. And after years of saving, it would be a big mistake to let these penalties dent your retirement nest egg.
The 6% penalty
Each year, the government allows you to deposit a set amount of money into an individual retirement account. For 2017, you can contribute the lesser of your annual earned income or $5,500, while those aged 50 or over can contribute up to $6,500. But what happens if you exceed the maximum allowable amount? The answer: You will owe a 6% penalty on the excess amount every year until it is withdrawn from the account.
Keep in mind that an excess contribution is not only when you contribute more than $5,500 (or $6,500). If you earn less than the maximum, then any contributions beyond your income will be considered excess. For example, if you are under age 50 and make $3,000 in a year, then you can contribute no more than that amount to an IRA that year.
The 10% penalty
If you save for retirement in a tax-sheltered account, you always have access to your money. However, withdrawing funds before you are age 59-1/2 will generally be deemed an early withdrawal and thus subject to a 10% penalty (in addition to whatever income taxes you may owe), unless you qualify for an early-withdrawal exception.
Of course, you can always choose to withdraw money early from your retirement account, but it's also possible to do so unintentionally if you're not careful. In particular, you'll face pitfalls when rolling over your retirement savings or taking a loan from your workplace retirement account.
If you plan to roll over your 401(k) or other workplace retirement account to an IRA, you should have your 401(k) administrator send a check directly to your IRA custodian. That way, the money is never in your hands, and there's virtually no chance things will go wrong. If you instead elect to receive a check payable to yourself, your employer will withhold 20% of your funds. You'll then have 60 days to deposit the full amount into an IRA, so you'll have to come up with that missing 20% yourself. Then, even if you successfully complete the rollover, you won't get that 20% back until tax time.
If you fail to redeposit the full rollover amount into an IRA, the IRS may deem this transaction as an early withdrawal, with penalties attached.
Similarly, if you take a loan from your 401(k) and leave the company for any reason before it is paid back, you will often have a limited time to repay it -- and failure to repay the loan on time will cause it to be deemed a distribution.
The 50% penalty
The main benefit of using tax-favored retirement accounts is decades of tax-free growth. However, you can't shield your money from taxes forever.
While you can always withdraw more than the required amount, taking less than the required minimum will result in a huge 50% penalty on the amount that you failed to withdraw.
Building and maintaining your retirement savings is difficult enough without having to lose money to harsh penalties. So remember to keep these missteps in mind the next time you tinker with your retirement account.