8 minute read
Retirement plans are one of the best ways an individual can save money for their eventual retirement. Planning ahead for retirement is something everyone should be doing. From determining what type of retirement account should be created to figuring out what tax consequences you’re subject to, planning for retirement takes time, patience, and a case-by-case analysis to decide what is best for you.
However, sometimes life takes an unexpected turn. Funds that were put away for retirement may need to be withdrawn to cover unexpected costs, like health-related expenses, money to cover a period of unemployment, having to support a loved one, or a downpayment for a new home.
This blog gives a brief overview of retirement accounts, discusses when and how individuals can withdraw early from their retirement accounts, and how COVID-19 relief has affected 401(k) and other retirement account withdrawals.
Retirement plans come in many different structures and have many different names. Determining which type of plan is best is often a detailed process that is different for each company or individual.
Some of the most common retirement accounts are:
No one plan is better than the other. Rather, each plan offers different benefits and downfalls that individuals should weigh when deciding which plan to choose. For example, a 401(k) plan offers higher contribution limits than an IRA. On the other hand, an IRA may allow the plan participant a wider array of options to invest in compared to a 401(k).
The tax consequences of each of these plans is complex, and the contributions made to—and distributions taken from—the plan(s) affects how the funds are taxed. As an example, some plans—typically Roth 401(k) and Roth IRA plans—make contributions to the plan with after-tax dollars, whereas standard 401(k) and IRA plans make contributions pre-tax and are taxed upon distribution.
What is the Early Withdrawal Penalty?
Generally, funds placed in a retirement account are not accessible until the participant has reached retirement age, which is usually considered 59½. Some plans can elect to allow the withdrawal age to be earlier or later than 59½.
If the plan participant withdraws funds prior to reaching their plan’s retirement age, the funds withdrawn will be subject to an early withdrawal penalty. The amount of the early withdrawal penalty is 10% of the amount withdrawn. So, if you withdrew $1,000 from your retirement account early you would be subject to a $100 tax.
Are Early 401(k) Withdrawals Subject to Tax?
Yes—in addition to the 10% penalty on the amount withdrawn, an early 401(k) withdrawal will also be taxed on the amount withdrawn. The applicable rate of tax will depend on the individual’s income tax rate. Notably, the tax due will also include any applicable state income tax.
When Can You Withdraw Penalty-Free?
There are certain situations where the withdrawal of funds from a retirement account is penalty-free. These situations are generally reserved for times of hardship or when an individual is in need during exceptional circumstances. Some examples of when the penalty is not applied to a retirement plan withdrawal include:
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What Relief Was Provided in the CARES Act for 401K Withdrawals?
Along with the normal exceptions for penalty-free withdrawals, Congress provided certain relief for 401(k) withdrawals that resulted due to financial effects of COVID-19. Specifically, the CARES Act states that up to $100,000 of COVID-19 related distributions from eligible retirement plans will not be subject to the 10% withdrawal penalty.
The distributions made are generally required to be paid proportionally over a three-year period, meaning the individual withdrawing the funds would receive an equal ⅓ of the distribution each year for three consecutive years. Taxes are due during the year in which the funds were received.
Taxpayers can also elect to include the entire distribution of their income for the year of the distribution rather than pay the taxes in increments over the three-year period. The election must be made on that year’s tax return and cannot be changed in future years.
Can Taxpayers Repay a COVID-19 Related Distribution?
One way that an individual can get back on track after taking out a COVID-19 related distribution is to replace it. Generally, a plan participant can choose to repay the funds back into the retirement plan. The repayment of funds must be completed within three years of the date the distribution was received. If the distribution is repaid, the plan participant will not owe income tax on the distribution.
The deadline to repay funds is based on the filing date of the individual’s tax return. For example, if the tax return containing the initial distribution was filed on October 15, 2020, then the taxpayer has until October 15, 2023, to repay the distribution. The initial distribution will be listed as income on the 2020 return. However, if the distribution is repaid by the deadline, the taxpayer will be allowed to amend the prior year tax returns to exclude the distribution from income and possibly receive a refund for tax paid in those periods.
Investing your income into a retirement account is crucial to planning your retirement account strategy, which can help ensure you retire on time—and stay retired! If someone needs to withdraw retirement funds early, they should ensure they are taking advantage of any available hardship or other special provisions to avoid any early withdrawal penalties and negative tax consequences. Ensure your retirement strategy is tax-advantaged.
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