When money gets tight, it can be tempting to think about your retirement accounts as a potential source of financial breathing room. However, an early withdrawal from your retirement account can quickly get costly. Learn more about the taxes, fees, and penalties that can come from an early retirement withdrawal, as well as some factors to consider if you feel your options are limited.
How Much Do Early Withdrawals Cost You?
Because of the preferential tax treatment retirement contributions receive, early withdrawals are not only penalized, but also taxed.[1] If you withdraw money from a tax-deferred retirement plan before you reach age 59.5, you'll pay a withdrawal penalty or tax of 10 percent in addition to any other income taxes you owe on the withdrawn amount.1 (Post-tax retirement plans like Roth IRAs allow early withdrawals of contributions, though an early withdrawal of gains is also subject to a penalty). The more money you withdraw, the larger your tax bill and penalties will be.
For example, if your top marginal tax rate is 33 percent, you'll pay a total of 43 percent in taxes on your early distributions; taking out $10,000 from a retirement account will net you only $5,700.
Exceptions to the Early Withdrawal Penalty
Not every early withdrawal is subject to this penalty (though all early withdrawals from tax-deferred accounts will be subject to income taxes). First-time homebuyers can withdraw up to $10,000 from a traditional IRA for a home purchase, while unemployed individuals may withdraw the same amount to pay for health insurance. Meanwhile, 401(k) account holders can avoid a penalty if they withdraw the funds when they are age 55 or older (and have retired or are unemployed) or are using the funds to pay medical bills.
Another Big Exception: CARES Act Withdrawals
In March 2020, the CARES Act made it easier to withdraw from retirement accounts in certain situations.1 If you contracted COVID-19 in 2020 or suffered financially due to the pandemic, you may be eligible to withdraw up to $100,000 from your retirement funds without paying penalties—and without having to prove that the funds were used for certain expenses like a home purchase or medical bills.[2] Though you'll still owe income taxes on the amount withdrawn, the elimination of the early withdrawal penalty can sometimes make this a more attractive option than taking out a loan or putting a large expense on a credit card.
Hidden Costs: Opportunity Cost
One cost of early retirement withdrawals that isn't always as apparent is the opportunity cost that comes from reducing your retirement account balance.[3] The time value of money is one of the most powerful influences on your future account balance. Every dollar you withdraw from a retirement account now could have grown to $5 or $10 by the time you retire.
For example, a $10,000 retirement account earning a modest 8.3 percent rate of return can grow to $35,000 in 30 years, even with no additional contributions. Withdrawing $2,000 from this account and leaving the remaining $8,000 to grow at the same rate of return means you'll end up with only $28,000 at the end of the same time period. When spread over time, this $2,000 withdrawal actually cost you $7,000.3
Whenever you're thinking of withdrawing from a retirement account, consider your time horizon. Generally, the younger you are and the smaller your total retirement account balance, the greater impact an early withdrawal might have.
Important Disclosures:
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial professional prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
All information is believed to be from reliable sources; however LPL Financial makes no representation as to its completeness or accuracy.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.
Contributions to a traditional IRA may be tax deductible in the contribution year, with current income tax due at withdrawal. Withdrawals prior to age 59 ½ may result in a 10% IRS penalty tax in addition to current income tax.
The Roth IRA offers tax deferral on any earnings in the account. Withdrawals from the account may be tax free, as long as they are considered qualified. Limitations and restrictions may apply. Withdrawals prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Future tax laws can change at any time and may impact the benefits of Roth IRAs. Their tax treatment may change. 1 https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-tax-on-early-distributions 2 https://www.irs.gov/newsroom/coronavirus-related-relief-for-retirement-plans-and-iras-questions-and-answers 3 http://www.fncalculator.com/financialcalculator?type=roiCalculator
[1] https://www.irs.gov/newsroom/what-if-i-withdraw-money-from-my-ira [2] https://www.irs.gov/newsroom/coronavirus-related-relief-for-retirement-plans-and-iras-questions-and-answers [3] https://www.forbes.com/sites/alexverkhivker/2017/04/24/early-withdrawals-from-retirement-savings-plans-what-is-the-real-opportunity-cost/?sh=5adad74323b1
Sources
https://www.irs.gov/newsroom/what-if-i-withdraw-money-from-my-ira https://www.irs.gov/newsroom/coronavirus-related-relief-for-retirement-plans-and-iras-questions-and-answers
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