Why would you give the government an extra cut out of your retirement nest egg if you didn’t have to? We all work too hard and save too diligently to just willingly give the Internal Revenue Service a bigger piece of our retirement pie. If you ever end up paying an early withdrawal penalty or early withdrawal fee for taking funds out of your retirement account, you’ve just served up free money to the government.
Photo by Purpleslog via Flickr
What is an Early Withdrawal Penalty?
All retirement accounts have stipulations about when you can withdraw funds. These stipulations dictate how old the individual must be to begin taking distributions without paying early withdrawal penalties. (They also show when you are forced to begin taking distributions for some type of retirement accounts.)
An early withdrawal penalty is what it sounds like: a fee you pay to the government for withdrawing funds (also called “taking a distribution”) before the allowed retirement age. If you are younger than the retirement age given for the account, you pay an early withdrawal penalty.
Exactly how much of a chunk of your withdrawal the government gets is dependent upon the specific retirement option you are withdrawing funds from.
Which Retirement Accounts Have an Early Withdrawal Penalty?
All retirement accounts have some sort of early withdrawal stipulation, but the details are different. The two key points are: how old you must be to withdraw funds while avoiding paying a penalty, and what the early withdrawal penalty is if you are below that age.
For most retirement accounts the target age you want to be before pulling funds out is 59 and 1/2. And for many retirement options the penalty you will pay if you are under that age is 10% of the withdrawal.
Here’s a short list of popular retirement accounts and the penalties you would pay on early distributions. Remember, the penalty is taken out of the withdrawal, not out of the account. A $1,000 withdrawal with a 10% penalty would net you $900 before you paid taxes on the remaining amount.
Tax Advantaged Accounts
|Account Type||Minimum Age||Penalty|
|401(k)||59 and 1/2||10%|
|403(b)||59 and 1/2||10%|
|Traditional IRA||59 and 1/2||10%|
After-Tax Retirement Accounts
|Account Type||Minimum Age||Penalty||Note|
|Roth IRA||59 and 1/2||10%||However, note that you can withdraw contributions to your Roth IRA at any time. The early withdrawal penalty only applies to withdrawals of Roth IRA earnings.|
Small Business Retirement Accounts
|Account Type||Minimum Age||Penalty||Note|
|SIMPLE IRA||59 and 1/2||10%||The early withdrawal penalty is 25% if the distribution is within 2 years of the SIMPLE IRA being established; if it is after the two-year period then the early withdrawal penalty is 10%.|
|SEP IRA||59 and 1/2||10%|
|Solo 401(k)||59 and 1/2||10%|
How to Avoid Paying Fees for Withdrawing Retirement Funds Early
Not all retirement account distributions are treated the same. If you simply want to withdraw the money to go spend on a vacation or some other unnecessary expense you will end up paying the early withdrawal fee unless you are over the age limit for the account.
However, there are certain instances where early distributions are allowed. These exceptions are account specific, so be sure to read up on your specific retirement account before withdrawing funds.
A few common exceptions include:
- Hardship distributions – funds needed for medical expenses or after becoming disabled
- Home ownership – funds used to purchase a home for the first time
- After death – funds distributed to beneficiaries after the account holder’s death
Remember, You’ll Owe Income Tax, Too (Except for Roth)
Ideally you don’t have a need to touch your retirement account until retirement. Even if you are able to withdraw early and avoid the penalty, remember that you will also have to pay income tax on the distribution if it is a tax-advantaged account. That can easily take 15-33% off the top of whatever amount you’re withdrawing.
It’s even worse if you have to pay the early withdrawal penalty. If you’re in the 28% tax bracket and withdraw $1,000 with an early with a penalty, you’ll lose a ton of money:
- $1,000 x 10% = $100 penalty, leaves $900
- $1,000 x 28% tax bracket = $280, leaves $620
- Total percentage lost to taxes and fees: 38%
You will also miss be forgoing any additional growth in the invested funds. If that $1,000 stayed invested for another 15 years and earned 8% on average, you would end up with almost $3,200.
Kevin Mulligan is a debt reduction champion with a passion for teaching people how to budget and stay out of debt. He’s building a personal finance freelance writing career and has written for RothIRA.com, Discover Bank, and many others.