Short of Cash? Avoid this Mistake!

Circumstances can occur that pressure people to withdraw money from their retirement account before their retirement date. This pressure can be created when a person is laid off from a job. It can be created when you need to pay an attorney to keep a fair haired son out of prison. Maybe a Mom and Dad feel the need to pay for their daughter’s wedding. The range of circumstances creating financial pressure that tempts a person to withdraw money from an IRA or retirement plan is wide and various. Giving in to this temptation can be costly.

If you have a traditional IRA or funds in an employer sponsored retirement account, you generally have to include any amount withdrawn from this account in your taxable income. If you haven’t reached age 59 ½ when you withdraw money from a retirement account, a 10% penalty is imposed on the taxable portion of the distribution. In Arkansas, the penalty for early withdrawal of funds from a retirement account is 1% of the taxable distribution. So let’s do some simple arithmetic.

How much would a $10,000 withdrawal from a traditional IRA (where 100% of the contributions had been deducted from your taxable income) cost a single person under age 59 ½ with taxable income of $40,000 before adding the IRA withdrawal (or distribution) in income? This person would pay 25% federal income tax bracket + a 10% penalty for early withdrawal + 7% Arkansas income tax + a 1% Arkansas penalty for early withdrawal. This totals 43%. So in this illustration, the person withdrawing $10,000 would only get to keep $5,700 after income taxes and penalties were paid. This illustration happens to real people all the time.

If you ever find yourself in this position, consider some alternative options first:

  • Ask Mom for a loan.
  • Ask the bank for a loan.
  • See if you can take a cash advance on your credit card.
  • Drive to Arkoma and find a finance company who will give you a high interest rate loan.

The above options are seem somewhat silly, except asking the bank for a loan, but they are alternatives costing you less money than withdrawing money from you retirement account. Many people never seek alternative options. But there is almost always an alternative option. Make an early withdrawal from a traditional IRA or a retirement account the last choice. But if it is you last option, do yourself a favor and have the bank or fund administrator withhold income taxes from the distributiion. Many people fail to have adequate income taxes withheld and find themselves is another bind on April 15th, when income tax are due.

Some fortunate individuals can find relief from the early withdrawal penalty. The IRS has allowed some exceptions to avoid the penalty. These exceptions are:

  • The distribution is made to an employee after separating from service in or after he reaches age 55.
  • The distribution is part of a schedule series of substantially equal periodic payments make over the life expectancy of the participant or joint live of the participant and his beneficiary.
  • The distribution is made due to total and permanent disability. (This individual should not be described as fortunate, as I described above.)
  • A distribution made due to death of the employee or account owner. (This would only be fortunate if you were the beneficiary).
  • A distribution made to the extent the individual’s unreimbursed medical expenses exceed 7.5% (10% after December 31, 2012 )of his adjusted gross income.
  • A distribution is made to an ex-spouse in a property settlement by reason of a qualified domestic relations order.
  • The distribution is made to pay for health insurance premiums for unemployed individuals.
  • The distribution is made to pay for qualifying higher education expenses during the year for the taxpayer, spouse, child or grandchild.
  • The distribution is made for first-time home purchases, limited to $10,000.
  • The distribution is due to an IRS levy.
  • You are a reservist and the distribution was while serving on active duty for at least 180 days.

There are some conditions and qualifications required for some of the above exceptions to apply. If an exception to the penalty is helping draw you to the dark side, make sure you know how the exception really works.

You put money in your retirement account for retirement. Treat this money as sacred.