It's a great question -- and one that I hear often. "What happens if I take money early from a 401(k) or IRA?" As you watch your money accumulate in a retirement account, it's natural to want to use some of it early, especially if you're in an economic bind. But it's important to remember that you'll also need those funds in the future. After all, that's why you opened the account in the first place.
Though I always recommend using early withdrawal from a 401(k) or individual retirement account only as a last resort, if you find yourself in a financial crunch, it is possible to make early withdrawals (early being defined by the IRS as before age 59 1/2) in certain circumstances. However, it is complicated -- and can be costly.
First, there are important differences between traditional accounts and Roth accounts.
If your 401(k) or IRA is traditional, your contributions are pretax. Any distributions of contributions or earnings at any time are subject to ordinary income taxes. Plus, there's most likely a 10 percent penalty if you're younger than 59 1/2.
If an account is a Roth, your contributions are made after taxes, and you can withdraw up to the amount of your contributions at any time -- at any age -- without taxes or penalties.
That's the simple answer. But of course, it's more complex than that because there are rules and exceptions. And here's where the devil's in the details.
An early withdrawal from a traditional 401(k) will be taxed as regular income and typically incurs a 10 percent penalty. In real terms, this means that if you're younger than 59 1/2 and you're in the 25 percent tax bracket, if you take $10,000 from your traditional 401(k), you'll pay $2,500 in federal taxes and $1,000 in IRS penalties. Your $10,000 will cost you $3,500 -- a pretty hefty price.
But taxes and penalties aside, the real issue here is that if you're still employed by the company sponsoring your plan, you can only take early withdrawals in very specific situations, if at all. For instance, you might qualify for what the IRS calls a "hardship distribution" if you can prove immediate and heavy financial need to pay for certain qualified expenses, such as funeral or higher-education costs, as set by the IRS.
But here's the catch. Even if the IRS allows a hardship distribution, your plan may not. Plus, no matter why you need the money, you'll still pay taxes and a 10 percent early withdrawal penalty. To avoid the penalty, you must meet some even more stringent requirements -- for instance, having your medical debt exceed 7.5 percent of your adjusted gross income or having become permanently disabled.
There are a couple of penalty-free possibilities if you are separated from service. If you leave or lose your job in the year you turn 55, you can take a lump sum 401(k) distribution without incurring the 10 percent early withdrawal penalty. If you have separated from service at any age before 55, you can set up "substantially equal payments" over your lifetime, which must be a minimum of five years or until you reach age 59 1/2, whichever is longer.
If your employer's plan allows it, a tax-free, penalty-free loan from your 401(k) might be the best option in a pinch. Your employer sets the terms, but it must be paid back on time and with interest.
Traditional IRAs are a little more flexible. You can take an early distribution at any time, subject to taxes and a 10 percent penalty before 59 1/2. However, you can avoid the penalty if the money is used to pay for specified costs, including higher education, a first-time home purchase and medical expenses exceeding 7.5 percent of your adjusted gross income. But no matter the circumstances, you'll always pay income taxes on withdrawals.
Roth accounts are the easiest. Both contributions and earnings are tax- and penalty-free at age 59 1/2, as long as you've held the account for five years. And as I said, you can take early distributions of contributions from a Roth 401(k) or IRA at any time without taxes or penalties. Any earnings on your contributions taken out before age 59 1/2 could cost you.
From possible taxes to penalties to the loss of long-term growth, an early withdrawal from a retirement account can really take a chunk out of your hard-earned savings. So think carefully and make sure you consider the long-term, as well as the upfront, costs. And as always, consult your tax adviser before taking any distributions.
Carrie Schwab-Pomerantz is a Certified Financial Planner. Her weekly column, "Ask Carrie," can be found at creators.com.