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Tax Planning for Retirement Plans: Weighing the Tax Consequences for Early Withdrawals

When the need for emergency funds arises, many taxpayers may be tempted to turn to their retirement accounts. However, if the account holder has not reached full retirement age (FRA), withdrawing those funds early can result in a slew of tax penalties and other deductions. Before pulling retirement funds, taxpayers need to know the rules surrounding early withdrawals and if they qualify for any special exemptions from taxation.

Taxpayers who withdraw retirement funds before age 59 ½ will get hit with an early withdrawal penalty from the IRS, in addition to any income tax required. In terms of federal taxes, withdrawing funds before the plan’s retirement age will result in a 10% early withdrawal penalty. Some states also have their own early withdrawal penalties. On top of this, the IRS generally requires withholding of 20% of an early withdrawal from a 401(k). So if a taxpayer makes an early withdrawal of $50,000, they may only receive about half of these funds after taxes, penalties, and withholding! 

Fortunately, some taxpayers may qualify for exceptions that will help them to sidestep these penalties. For example, many retirement plans, such as 401(k), SIMPLE, and SARSEP IRA accounts, qualify for an exception if the plan includes automatic enrollment. If the employee makes an election to qualify for the exception, that employee can withdraw their contributions effective either on their next pay date or 30 days after the first pay date that’s affected by that election. 

One disadvantage to this route is that the employee will forfeit any matching employer contributions for the funds that are withdrawn early. Also, if the withdrawn amount has not yet been taxed, it will be considered taxable compensation for the employee. The advantage is that the withdrawn amount is not subject to the 10% federal penalty. 

Another exception occurs if you’ve contributed to a 401(k) in excess and are allotted a corrective distribution. This also applies to the associated earnings of those distributions. Determining if someone qualifies for a corrective distribution is a formal process involving actuaries employed by the third party administrator (TPA) to decide if there has been discrimination in the plan design itself. If you do have excess contributions, these will be refunded without tax penalty.

The death of the plan participant or the IRA owner will also act as an exception. The heirs who receive the IRA can choose to spend that fund without an early withdrawal penalty. However, those heirs will still have to deal with the regular income tax consequences. 

Disability can qualify you for an early withdrawal. The key to this exception is the permanence of the condition, rather than the severity of the condition. The taxpayer will have to provide documentation from a doctor proving the permanence of the disability. They may also need written statements from Social Security that documents the disability.

A qualified domestic relations order (QDRO) from the courts can mandate that a spouse give funds from their account to a former spouse, a child, or a dependent. In this case, the funds are exempt from the tax penalty. If the recipient chooses to spend that money and not roll it over into their own retirement account, they will have to deal with the applicable income tax and withholding rules. 

Qualified higher education expenses are another great exception for students attending any accredited university, college, or vocational school. These expenses can include administrative fees charged by the school, books, supplies, and equipment. If the student attends school more than half-time, the cost of room and board is also covered. To qualify for the penalty exception, the expenses must occur within the same year of the distribution, so unfortunately, these funds cannot be used to pay off a student loan after graduation. 

Early retirement withdrawals can be a means to offset unexpected expenses, but taxpayers need to be aware of the significant deductions that could apply. If the taxpayer does not qualify for any penalty exceptions, they may want to reevaluate the costs and benefits of leveraging these specific funds. Become well-versed in the best tax strategies and save your clients more money by enrolling in our training to become a Certified Tax Planner.

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