When your retirement accounts are growing, it’s great to see the numbers climb. But when you retire and start withdrawing money from your IRA and 401(k), the taxes you owe can take a surprisingly big chunk out of your total.
Hopefully, you’re taking advantage of the tax breaks that come with contributing to most retirement accounts, but are you ready for the taxes you’ll face when you start taking withdrawals?
The general rule for retirement accounts is that you either pay taxes on the money before you put it into the account or when it comes out. Determining which is better for your situation and what to expect with your accounts begins by understanding the distribution and early withdrawal rules for the various types of retirement accounts.
Early Withdrawal Penalties
How the IRS treats retirement account distributions depends on the type of plan.
1. Individual Retirement Account (IRA)
You can contribute up to $6,000 (or $7,000 if you’re 50 or older) into a traditional or Roth IRA for 2020 and 2021. If you have multiple IRAs, you can’t go over that limit for all accounts combined.
There are two types of IRA, each with its own tax implications for contributions and withdrawals. You can open these types of accounts through brokers like SoFi and TD Ameritrade.
- Traditional IRA: You can deduct contributions to a traditional IRA up to the annual contribution limit to reduce your taxable income. Funds in the account grow on a tax-deferred basis, meaning you don’t have to pay taxes on interest, dividends, or capital gains earned within the account. However, when you start making withdrawals in retirement, you’ll pay income taxes on the distributions.
- Roth IRA: A Roth IRA is essentially the opposite of a traditional IRA. You can’t deduct contributions, but your money grows tax-free and withdrawals are tax-free in retirement.
Both traditional and Roth IRAs may penalize account holders who take distributions before age 59½. In a traditional IRA, withdrawals made before that age are taxable and hit with a 10% early withdrawal penalty.
For a Roth IRA, contributions can be withdrawn tax-free at any time after meeting a five-year holding period. However, you generally have to pay a 10% penalty on earnings withdrawn before age 59½. There are a few exceptions to the early withdrawal penalty (more on them below).
2. 401(k)
Many employers offer a 401(k) plan and deduct contributions from employees’ wages. Contributions to a 401(k) reduce your adjusted gross income, lowering your overall tax liability. Employers may also match contributions up to a certain percentage of your salary.
The maximum contribution to a 401(k) plan is $19,500 for 2020 and 2021. Employees ages 50 or older can make an additional “catch-up” contribution of $6,500.
When you start taking distributions in retirement, you’ll have to pay taxes on your original contributions and on the account’s earnings. If you withdraw funds before age 59½, you may have to pay a penalty of 10% of the amount withdrawn, in addition to your regular income tax rate.
Some employers now offer Roth 401(k) plans, which are similar to a Roth IRA in that contributions don’t lower your taxable income now, but distributions are tax-free in retirement.
Pro tip: If your employer offers a 401(k), check out Blooom, an online robo-advisor that analyzes your retirement accounts. Simply connect your account, and you’ll quickly be able to see how you’re doing, including risk, diversification, and fees you’re paying. Plus, you’ll find the right funds to invest in for your situation. Sign up for a free Blooom analysis.
3. 403(b) & 457(b)
403(b) and 457(b) accounts are the equivalents of a 401(k) plan but for employees of nonprofit or governmental entities, respectively. As with a 401(k) plan, the maximum annual contribution to 403(b) and 457(b) plans is $19,500 for 2020 and 2021, with an additional catch-up contribution of $6,500 for employees ages 50 or older.
403(b) plans also face a 10% penalty for early withdrawals.
4. SIMPLE IRA
A Savings Incentive Match Plan for Employees (SIMPLE) IRA is an option many small businesses use because it’s less expensive to administer than a 401(k) plan. These accounts are similar to 401(k)s in that employees contribute money pre-tax and pay taxes on withdrawals.
Employee contributions to a SIMPLE IRA are limited to $13,500 in 2020 and 2021. Employees ages 50 or older can make catch-up contributions of up to $3,000. Employers are generally required to match employees’ salary contributions on a dollar-for-dollar basis up to 3% of the employee’s compensation.
The early withdrawal penalty for distributions from a SIMPLE IRA is 10% unless you’ve been participating in a SIMPLE IRA for less than two years, in which case the penalty increases to 25%.
5. SEP IRA
A Simplified Employee Pension (SEP) IRA is a low-cost, easy-to-manage account for self-employed people and business owners with five or fewer employees. These accounts follow similar rules and withdrawal penalties as a traditional IRA.
However, the business owner can contribute up to the lesser of $57,000 or 25% of the employee’s compensation for 2020. That limit rises to $58,000 for 2021.
Exceptions to the Early Withdrawal Penalty
The pile of paperwork you receive when you sign up for a retirement account likely includes warnings about penalties on early withdrawals, so they should come as no surprise.
For early withdrawals made in 2020, the Coronavirus Aid, Relief and Economic Security (CARES) Act temporarily waived penalties on early withdrawals of up to $100,000 from IRAs and employer-sponsored retirement accounts.
The withdrawals may still count as taxable income, but you have the option of including one-third of the money as taxable income for each of the next three years.
To qualify for the penalty waiver, you must have a COVID-19-related hardship. Valid hardships include:
- A positive COVID-19 test for you, your spouse, or a dependent
- Losing your job
- Being furloughed from your job
- A reduction in hours
- Owning a business that faced negative financial impacts due to the pandemic
- Inability to work or lack of child care due to COVID-19
- Delayed or rescinded job offer due to the pandemic
Outside of the special CARES Act rules, if you want to avoid the 10% – or, in some cases, 25% – penalty, there are a few exceptions.
1. Roth IRA
You can withdraw contributions made to a Roth IRA at any time, tax- and penalty-free. However, you may have to pay taxes and penalties on earnings within the account, depending on your age and how long you’ve had the account.
Under Age 59½, Owned Roth IRA for Less Than 5 Years
If you’re under age 59½ and take a distribution from a Roth IRA you’ve owned for less than five years, the earnings may be subject to taxes and penalties. You can avoid penalties – but not taxes – if:
- You use the funds to pay for your first home (up to a $10,000 lifetime maximum)
- You use the funds to pay for qualified education expenses
- You become disabled or pass away
- You use the funds to pay for unreimbursed medical expenses or health insurance while unemployed
- The distribution is made in substantially equal periodic payments
Under Age 59½, Owned Roth IRA for 5+ Years
If you’re under age 59½ and you’ve owned your Roth account for five or more years, you can withdraw earnings without taxes or penalties if:
- You use the funds to pay for your first home (up to a $10,000 lifetime maximum)
- You become disabled or pass away
- You use the funds to pay for unreimbursed medical expenses or health insurance while unemployed
- The distribution is made in substantially equal periodic payments
Once you reach age 59½, as long as you’ve owned your Roth IRA for at least five years, you can withdraw money from the account with no taxes or penalties. If you haven’t met the five-year holding requirement, the earnings will be taxable income, but you won’t have to pay a penalty.
2. Traditional IRA, SIMPLE IRA & SEP IRA
If you take early withdrawals from a traditional IRA, SIMPLE IRA, or SEP IRA, you’ll likely pay a penalty as well as income taxes on the distribution unless you meet one of the following exceptions.
- Disability: You become total and permanently disabled.
- Death: Amounts are withdrawn by your beneficiary or estate after your death.
- Medical: Funds are used to pay for unreimbursed medical expenses or health insurance premiums while you’re unemployed.
- Education: Funds are used to pay for qualified higher education expenses.
- Homebuyers: Funds are used to pay for a first home (up to a $10,000 lifetime maximum)
- IRS Levy: Funds are levied by the IRS to pay an unpaid tax liability.
- Military: You are a qualified military reservist called to active duty.
3. 401(k), 403(b) & 457(b)
If you want to withdraw money from a 401(k) or 403(b) plan without penalties, you’ll need to meet one of the following exceptions:
- Disability: You become total and permanently disabled.
- Death: Amounts are withdrawn by your beneficiary or estate after your death.
- Divorce: Funds are paid to an ex-spouse under a qualified domestic relations order.
- Medical: Funds are used to pay for unreimbursed medical expenses.
- IRS Levy: Funds are levied by the IRS to pay an unpaid tax liability.
- Military: You are a qualified military reservist called to active duty.
- Retirement: You retire at age 55 or older.
Distributions from a 457(b) plan aren’t subject to a 10% penalty on early withdrawals unless the funds distributed came from a rollover from another type of plan.
4. Rollovers
You aren’t liable for taxes or penalties when completing a direct rollover to another IRA or transferring money from one IRA to another without taking possession of the money. However, you’re only allowed to make one rollover per year.
You can also take a lump-sum payout from a retirement account and avoid taxes and penalties as long as you deposit the money into another eligible retirement account within 60 days.
5. Substantially Equal Periodic Payments
If you decide to retire early and need to tap your retirement savings before the age of 59½, one little-known way to avoid early withdrawal penalties is to set up substantially equal periodic payments. It’s like giving yourself an annual salary.
However, withdrawals must be spread over your life expectancy. The IRS publishes life expectancy tables annually that determine the amount you can withdraw each year.
Required Minimum Distributions (RMDs)
While withdrawing from your retirement account too soon can result in penalties, the IRS also has rules that prevent you from taking distributions too late. Required minimum distributions (RMDs) are withdrawals you must make starting the year you turn 72.
The amount of your RMD depends on your age, marital status, and the total value of your retirement accounts. The IRS has a Required Minimum Distribution Worksheet that can help you calculate the required minimums.
You can’t put off taking RMDs from an IRA. The companies that manage retirement accounts send annual reports to the IRS. If the IRS sees that you’re not taking RMDs, you may face a penalty of up to 50% of the amount you should have withdrawn.
You can’t avoid this by turning around and depositing the withdrawals into another retirement account, but you can move the funds to an interest-bearing savings account like one at CIT Bank.
The CARES Act suspended all RMD requirements for 2020, but they do apply in 2021.
One exception is a Roth IRA, which doesn’t have RMDs and doesn’t require withdrawals until after the death of the owner. Additionally, if you’re still working at age 72, unless you own shares in your company, you can delay RMDs from employer-sponsored accounts, such as 401(k)s, until the year you retire.
If you have more than one retirement account, you must calculate your RMD separately for each account. If you have multiple IRAs, you can calculate the RMD separately but then withdraw the total amount from one or more of your IRAs.
The same rules apply for 403(b) plans. However, RMDs from other retirement plans, such as 401(k)s and 457(b)s, must be taken separately from each account.
If you inherit an IRA, 401(k), or another retirement account from someone who was not your spouse, you can choose to either withdraw the entire amount within five years of the original owner’s death or take required minimum distributions over your lifetime. Taking the entire amount can mean a huge tax hit, so many people choose to take RMDs to spread out the tax burden.
Final Word
It’s important to understand the tax implications of your retirement accounts so you know how much money you’ll have available when you need it. Many people focus on their account balance instead of the amount they’ll actually see after taxes, but the last thing you want is to realize you’ll need to delay your retirement because taxes will take a chunk of the income you were counting on.
If you aren’t already doing so, consider investing in a Roth IRA or Roth 401(k) to make tax time a lot less painful in retirement age.
