No matter how much people plan, unexpected events occur. Often, those events result in unplanned expenses. To cover these costs sometimes people, withdraw funds from their retirement savings early. While this may seem like an easy way to get cash quickly, early withdrawals can come with heavy penalties and costly tax consequences. Here’s some important info for people to consider before they dip into their hard-earned retirement savings.
Workplace Retirement Plans: 401(k), 403(b) and 457(b)
These plans can distribute benefits only when certain events occur. The plan’s summary description should clearly state when a distribution can occur. It will also state if the plan allows hardship distributions, early withdrawals, or loans.
- Hardship distributions are withdrawals from a participant’s account made because of an immediate and heavy financial need and it’s limited to the amount necessary to satisfy that financial need. The need of the employee includes the need of the employee’s spouse or dependent.
- Hardship distributions are includible in gross income unless they consist of designated Roth contributions.
- Distributions before the participant turn 65, or the plan’s normal retirement age, if earlier, may result in an additional income tax of 10% of the amount withdrawn.
- Repaying hardship distributions to the plan or rolling it over to another plan or IRA isn’t permitted.
Borrowers repay loans from these plans back to the retirement account. Borrowers should review the limits on loan amounts and other requirements. Taxes on this money don’t occur if the loan meets the rules and repayment happens on schedule.
Required Minimum Distributions
Taxpayers must make required minimum distributions each year beginning with the year the taxpayer turns 72, 70 ½ if the taxpayer turned 70 ½ in 2019. People calculate the RMD by dividing the IRA account balance as of December 31 of the prior year by the applicable distribution period or life expectancy. RMDs are waived for 2020 due to COVID-19 relief provisions. Required minimum distributions are not required for Roth IRAs.
IRAs and IRA-based plans
Individuals can take distributions from their IRA, SEP-IRA, or SIMPLE-IRA at any time. Taxpayers do not need to show a hardship to take a distribution – they can just contact the financial institution managing the account.
Early distributions occur when individuals withdraw money from an Individual Retirement Account or retirement plan before age 59½. These retirement plan distributions are subject to income tax. Individuals must also pay an additional 10% early withdrawal tax unless an exception to the early distribution tax applies.
Regardless of age, the account holder must file a Form 1040 Individual Income Tax Return showing the amount of the withdrawal and complete and attach a Form 5329, Additional Taxes on Qualified Plans, Including IRAs, and Other Tax-Favored Accounts, to the tax return. These are requirements for early withdrawals and regular distributions.
Coronavirus-related distributions and loans
The CARES Act made it easier to access savings in IRAs and workplace retirement plans for those affected by the coronavirus. Certain distributions made from January 1, 2020, through December 30, 2020, from IRAs or workplace retirement plans to qualified individuals may be treated as coronavirus-related distributions.
- These distributions aren’t subject to the 10% additional tax on early distributions, including the 25% additional tax on certain SIMPLE IRA distributions.
- Repayment to an IRA or workplace retirement plan can occur within three years.
Taxpayers can include Coronavirus-related distributions in income over 3 years, one-third each year, or if elected, in the year of the distribution.
Early distributions taken from a traditional IRA to satisfy divorce requirements or court orders are subject to regular income tax requirements and the 10% additional tax unless there is a qualifying exception.