This article from the Oklahoma Society of Certified Public Accountants is one you'll want to share with your clients to help them make wise decisions about early retirement plan withdrawals.
The money you've built up in a retirement savings account can look awfully tempting at times, particularly in an uncertain economy. If you feel you have no choice but to withdraw from a retirement account, you may find that it's a costly option because of the potential taxes and penalties involved.
The Oklahoma Society of Certified Public Accountants (OSCPA) explains the price you'll have to pay and how the exceptions to the rules work.
Early distributions often earn a double whammy
As a general rule, if you take an early distribution from a qualified retirement plan or deferred annuity contract before age 59½, you'll be hit with a double whammy of penalties. First, you'll have to pay ordinary income taxes on your withdrawal. In addition, you'll face a 10 percent penalty on the amount because of the early withdrawal. Those two rules apply to 401(k)s and traditional IRAs. With a Roth IRA, a qualified distribution escapes taxes and penalties, but a nonqualified distribution doesn't. Since the distinctions between the two are complicated, be sure to consult your CPA for more information. In all cases, the taxation and penalty don't apply to distributions that are rolled over into another qualified retirement plan.
How do exceptions work?
There are several exceptions to the penalties. Retirement plans may permit withdrawals when there's an "immediate and heavy" financial need. The IRS describes needs that fit this definition, and they may vary based on each situation. However, it's safe to say there would be no exception if you have other resources to address the need. The need may relate to you, your spouse, or a dependent. In its guidance, the IRS includes funeral or medical expenses in this definition.
There are education and health exceptions
There are also exceptions relating to education and health concerns. The penalty generally doesn't apply (although the tax may) for withdrawals made to cover qualified higher education expenses for yourself, your spouse, or your children or grandchildren. When it comes to health concerns, you may take early withdrawals if you're totally or permanently disabled. In addition, you can tap into your retirement funds to cover medical expenses that add up to more than 7.5 percent of your adjusted gross income. Only deductible medical expenses paid in the year the distribution is taken qualify for the exception.
Distributions work for unemployed medical insurance
You can also take a penalty-free early distribution for health insurance premiums if you're unemployed, have received unemployment compensation for at least twelve consecutive weeks, and have taken the distributions during the same year in which the unemployment compensation is made, or the succeeding year. But, these payments are limited to the actual amount paid for insurance for the employee, his spouse, and their dependents. In addition, taxpayers who are self-employed qualify for this exemption if self-employment is the only reason they don't qualify for unemployment compensation.
Use distributions for home sweet home
A qualified first-time homebuyer can take a distribution and escape the 10 percent penalty to the extent that the distribution is used by the individual to pay a qualified acquisition cost for a principal residence. Distributions can be up to $10,000 during the individual's lifetime, provided they are used within 120 days of withdrawal to buy, build, or rebuild a first home that is the principal residence of the individual; his or her spouse; or any child, grandchild, or ancestor of the individual or spouse.
Take periodic payments
Another exception comes into play in certain circumstances when you take distributions in a series of substantially equal periodic payments over your own life expectancy or the life expectancies of yourself and your designated beneficiary. These withdrawals must be taken at least annually, and there are complicated approaches to calculating them and ensuring that they remain tax free. Be sure to contact your CPA if you want more information.
Remember these additional considerations
There are no penalties if you withdraw funds under a qualified domestic relations order in a divorce case or if you use them to satisfy an IRS levy. Money paid to your beneficiary or your estate also escapes the penalty. Military reservists who've been called to active duty for at least 180 days can also withdraw from their retirement accounts without facing a penalty.
Consult your CPA
As a general rule, if you need money in a pinch, it's best to draw first from your emergency funds or from any investments that you have. If you don't have a nest egg available and are seriously considering withdrawing from a retirement account, given the complexity of the rules on retirement plan withdrawals, be sure to turn to your CPA. He or she can provide advice you need to make smart decisions.
For more personal financial planning advice, visit KnowWhatCounts.org. You may also want to read the Money Management (Dollars & Sense) columns, which are a joint effort of the AICPA and the OSCPA as part of the profession's nationwide 360 Degrees of Financial Literacy program.