Thursday, March 6, 2008

Early Retirement Withdrawl: Your Money, Your Worst Enemy

Yes, it's your money. But it's not your money to spend until you reach 59 1/2 and/or your plan reaches its distribution period. Many people don't understand this. They also don't understand that there is a penalty (usually 10%) for early withdrawal on top of tax (usually another 10%) on the money withdrawn. AND the money withdrawn needs to be reported to the IRS since it's income.

So, basically withdrawing money early will mean an automatic loss of 20%. That's staggering. But there is a silver lining...

Some retirement plans are not taxable, such as Roth (since Roth money is contributed after-tax). Additionally, only the portion that is taxable (i.e. has never been taxed before), will be taxed. So, if you early withdraw from a Roth, nothing will be taxed since that money has already been taxed and is set to grow tax free. However, if you early withdraw from a Traditional 401k, all the money was contributed tax-free, so at time of withdrawal, it is taxed.

Basically, the easy way to say it is if you'll be taxed on the money when it is disbursed, you'll get taxed on it when you early withdraw.

And remember, no matter what plan it is, you cannot get out of the early withdrawal penalty!!!

For more in-depth info on taxes on retirement plans, see the following links:

  • Publication 575, Pensions and Annuities (PDF 227K)
  • Publication 590, Individual Retirement Arrangements (IRAs) (PDF 449K)
  • Form 5329, Additional Taxes on Qualified Plans (including IRAs) and Other Tax Favored Accounts (PDF 72K)
  • Form 5329 Instructions (PDF 40K)
See here for more of my articles on retirement accounts.

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