It’s encouraging to see your retirement savings grow over time. But the taxes you owe can take an unexpectedly large bite out of your total when you retire and start taking money from your IRA and 401(k).
You should definitely take advantage of the tax deductions available for contributions to most retirement plans, but have you considered how much money you’ll have to pay in taxes if you begin withdrawing money?
When it comes to retirement funds, the usual rule is that taxes are paid either on the money before it is deposited or on the money after it is withdrawn. Getting familiar with the distribution and early withdrawal restrictions for the various retirement plan types is the first step in deciding which is best for your scenario and what to expect with your funds.
Penalties for Early Withdrawal
Distributions from retirement accounts are dealt with differently by the IRS depending on the kind of plan.
- Individual Retirement Account (IRA)
In 2020 and 2021, the maximum yearly contribution to a regular IRA is $6,000 (or $7,000 if you’re 50 or older). Even if you have more than one IRA, the total value of all of them cannot exceed the IRA maximum.
Both Roth and traditional IRA contributions and distributions are subject to different tax rules. Brokers like SoFi and TD Ameritrade allow its clients to establish these accounts.
- Contributions to a regular IRA are tax deductible up to the yearly maximum. You won’t have to pay taxes on interest, dividends, or capital gains accrued by your account while they grow tax-deferred. However, payouts from your retirement account will be subject to income tax once you begin taking them.
- When compared to a standard IRA, a Roth IRA is very different. Your payments aren’t tax deductible, but the money can grow tax-free and be withdrawn tax-free when you reach retirement age.
Withdrawals made from a regular or Roth IRA before the age of 5912 may incur a penalty. Withdrawals from a conventional IRA prior to age 59 1/2 are subject to income tax and a 10% early withdrawal penalty.
After the required five-year term of holding a Roth IRA, contributions can be withdrawn tax-free. Earnings removed before age 5912 are subject to a 10% penalty. For some situations, the early withdrawal fee may be waived (more on them below).
- 401(k)
The 401(k) plan is a common way for companies to save money by having their employees save some of their paychecks. To lessen your tax burden, 401(k) contributions are deducted before calculating your adjusted gross income. Contributions may be matched by employers up to a certain percentage of pay.
In both 2020 and 2021, the 401(k) contribution cap will be $19,500. Those who are 50 or older are eligible to make a “catch-up” payment of $6,500.
Taxes must be paid on both the contributions you made and the earnings in the account when you begin taking withdrawals in retirement. Money taken out of a retirement account before age 5912 may be subject to a 10% early withdrawal penalty on top of the standard income tax rate.
There are now employers who provide Roth 401(k) plans, which are quite similar to Roth IRAs in that contributions don’t reduce your taxable income now but payouts are tax-free in retirement.
- 403(b) & 457(b)
For those working in the nonprofit and public sectors, respectively, a 403(b) or 457(b) account serves as the equivalent of a 401(k) plan. In 2020 and 2021, the maximum yearly contribution to a 403(b) or 457(b) plan is the same as it is for a 401(k) plan: $19,500, with a catch-up contribution of an extra $6,500 for employees age 50 or older.
To withdraw money from a 403(b) plan early will cost you 10%, just like with 401(k)s.
- SIMPLE IRA
Because of its lower administrative costs compared to 401(k) plans, the Savings Incentive Match Plan for Employees (SIMPLE) IRA is used by many small firms. Contributions to these funds are made by workers before taxes and withdrawals are subject to taxation, much as 401(k)s.
In 2020 and 2021, the maximum annual contribution to a SIMPLE IRA by an employee is $13,500. Workers who are 50 or older are eligible to make $3,000 in “catch-up” payments.
To the extent that an employee contributes more than 3 percent of his or her pay, the employer must contribute an equal amount. If you’ve only had a SIMPLE IRA for less than two years, you’ll have to pay a 25% early withdrawal penalty on your payouts.
- SEP IRA
For sole proprietors and company owners with five or fewer workers, the Simplified Employee Pension (SEP) IRA is a low-cost, simple retirement plan option. Withdrawal penalties and other policies are analogous to those of a standard Individual Retirement Account.
If the employee’s 2020 salary is less than $57,000, the company owner can contribute up to the smaller amount. In 2021, that cap will be raised to $58,000.
Exceptions to the Penalty for Early Withdrawal
The warnings concerning early withdrawal penalties are likely to be included in the stack of documents you receive when opening a retirement account, so you should not be surprised by them.
The penalty for early withdrawals of up to $100,000 from IRAs and employer-sponsored retirement funds were temporarily lifted in 2020 thanks to the Coronavirus Aid, Relief, and Economic Security (CARES) Act.
Even if the withdrawals are considered taxable income, you can spread the tax hit out over three years by declaring a third of the total in each of those years. You must be facing hardship due to COVID-19 in order to be eligible for the penalty waiver. Among the list of legitimate difficulties are:
- The results of a COVID-19 test reveal that you, your partner, or one of your dependents has the virus.
- Getting fired
- Losing your job due to a furlough
- Time spent working will be cut down.
- Being the owner of a company that felt the effects of the epidemic financially
- Limitations on Employment or Access to Childcare Caused by COVID-19
- Job offers postponed or withdrawn because of the epidemic
If you wish to escape the 10% (or, in certain situations, 25%) penalty but aren’t covered by the CARES Act’s specific restrictions, you can still do so in a few circumstances.
- Roth IRA
Withdrawals from a Roth IRA are always free of taxes and penalties. You may, however, be subject to taxes and penalties on any earnings within the account, depending on your age and the length of time you’ve owned it.
Owned a Roth IRA for less than 5 years if you are under the age of 5912.
Earnings in a Roth IRA that you have owned for less than five years may be subject to taxes and penalties if you withdraw them before you turn 5912. Unlike taxes, fines may be avoided even if you make a mistake.
- You can use the money to buy your very first property, up to a maximum of $10,000.
- You put the money toward legitimate school bills.
- A disability or death occurs to you.
- While jobless, you utilize the money to cover health insurance premiums or out-of-pocket medical costs not covered by your policy.
- Payments will be made on a periodic basis, and will be fairly equal in amount.
Under Age 59½, Owned Roth IRA for 5+ Years
Earnings in a Roth IRA can be withdrawn tax and penalty free if you are under age 5912, provided you have owned the IRA for at least five years.
- You can use the money to buy your very first property, up to a maximum of $10,000.
- A disability or death occurs to you.
- While jobless, you utilize the money to cover health insurance premiums or out-of-pocket medical costs not covered by your policy.
- Payments will be made on a periodic basis, and will be fairly equal in amount.
In order to withdraw funds from your Roth IRA tax-free and penalty-free after age 5912, you must have owned the account for at least five years. The earnings will be taxable income but there will be no penalty if the five-year holding period has not been reached.
- SEP IRA, SIMPLE IRA, and Traditional IRA
Except in the cases below, individuals who withdraw funds from a traditional IRA, SIMPLE IRA, or SEP IRA before the end of the account’s designated withdrawal period are subject to a 10% early withdrawal penalty in addition to income taxes on the distribution.
- You’ve suffered a total and permanent disability.
- Once you pass away, your beneficiary or estate can access the funds.
- Medical: Money can be used toward private health insurance premiums or out-of-pocket medical costs that you incur while out of work.
- Education: Money is used to cover approved college costs.
- First-time purchasers: Money can be used to purchase a home (up to a $10,000 lifetime limit).
- Taxes that have not been paid may result in a levy by the Internal Revenue Service.
- You have been summoned to active duty as a qualified military reservist.
- 401(k), 403(b) & 457(b)
Withdrawals from your 401(k) or 403(b) plan are subject to penalties unless you fall into one of the following categories:
- You’ve suffered a total and permanent disability.
- Once you pass away, your beneficiary or estate can access the funds.
- After a divorce, an ex-spouse may get financial support from a court by way of a domestic relations order.
- The money is utilized for medical purposes, namely for out-of-pocket costs.
- Taxes that have not been paid may result in a levy by the Internal Revenue Service.
- You have been summoned to active duty as a qualified military reservist.
- Retirement age is 55 or older.
The 10% early withdrawal penalty does not apply to distributions from a 457(b) plan unless the assets were rolled over from another form of plan.
- Rollovers
Direct rollovers to another IRA, as well as transfers of funds between IRAs without gaining custody of the money, are exempt from taxes and penalties. Only one rollover can be made annually.
If you withdraw money from your retirement account and then put it into another qualified retirement account within 60 days, you won’t have to pay taxes or penalties on the withdrawal.
- Periodic payments that are substantially equal
Setting up substantially equal recurring payments is a little-known strategy for avoiding early withdrawal penalties if you need to start withdrawing money from your retirement account before you turn 59 12. This is like paying oneself a wage for a full year.
Withdrawals, though, have to be staggered throughout the course of your expected lifespan. The amount you can withdraw each year is based on the IRS’s life expectancy figures, which are published yearly.
Minimum Distributions Required (RMDs)
The Internal Revenue Service has restrictions that limit you from collecting withdrawals from your retirement account if you do so later than required. When you reach the age of 72, you must begin taking what are called “required minimum distributions” (RMDs).
Your Required Minimum Distribution (RMD) is calculated using your age, marital status, and the value of all of your retirement funds. There is a Required Minimum Distribution Worksheet available from the IRS that may be used for this purpose.
Required Minimum Distributions (RMDs) from an Individual Retirement Account (IRA) are non-deferrable. Investment firms that handle retirement funds file annual filings with the Internal Revenue Service. When the IRS discovers that you haven’t been withdrawing your RMDs, they can impose a penalty of up to half of the amount you should have taken out.
You can’t get around this by putting the money back into your retirement account, but you can put it into an interest-bearing savings account at a bank like CIT Bank. All RMD obligations for 2020 were waived by the CARES Act, however they will resume in 2021.
A Roth IRA stands apart since it doesn’t call for withdrawals until after the owner’s death and doesn’t have required minimum distributions. The required minimum distribution (RMD) from an employer-sponsored account (e.g., a 401(k)) can be postponed until the year of retirement if you are still working at age 72 and do not own shares in your firm.
If you have several retirement accounts, you must determine the RMD for each account separately. You can withdraw the required minimum distribution (RMD) from any one or more of your individual retirement accounts (IRAs), even if you have more than one.
For 403(b) plans, the same regulations apply. However, RMDs from other retirement plans like 401(k)s and 457(b)s must be withdrawn independently from each account.
You can take the whole amount out of a non-inherited spouse’s IRA, 401(k), or other retirement account within five years after the original owner’s death, or you can take RMDs throughout the rest of your life. Many people prefer to accept RMDs rather than the whole sum since doing so spreads out the tax bite.
Bottom Line
You need to know how much of your retirement savings will be accessible once taxes are deducted. The last thing you want is to have to delay your retirement because taxes will take a piece of the income you were banking on and then find out you have to delay it because of your account balance.
You can ease the financial burden of paying taxes in retirement by contributing to a Roth IRA or Roth 401(k) if you haven’t previously.
