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The money that you’ve built up in a retirement savings account can look tempting at times, particularly in an uncertain economy. If you feel you have no choice but to withdraw from a retirement account, you may find that it’s a costly option because of the potential taxes and penalties involved.
The California Society of CPAs explains the price you’ll have to pay and how the exceptions to the rules work.
Generally, if you take an early distribution from a qualified retirement plan or deferred annuity contract before age 59½, you will be hit with a double whammy of penalties. First, you will have to pay ordinary income taxes on your withdrawal. In addition, you’ll face a 10 percent penalty on the amount because of the early withdrawal. Those two rules apply to 401(k)s and traditional IRAs.
With a Roth IRA, a qualified distribution escapes taxes and penalties, but a non-qualified distribution does not. Since the distinctions between the two are complicated, be sure to consult your CPA for more information. In all cases, the taxation and penalty don’t apply to distributions that are rolled over into another qualified retirement plan.
There are several exceptions to the penalties. Retirement plans may permit withdrawals when there is an “immediate and heavy” financial need. The Internal Revenue Service notes that needs that fit this definition may vary based on each situation. If you have other resources to address the need, however, there would be no exception
The need may relate to yourself, your spouse or a dependent. In its guidance, the Internal Revenue Service includes funeral or medical expenses in this definition.
There are also exceptions relating to education and health concerns. The penalty generally doesn’t apply (although the tax may) for withdrawals made to cover qualified higher education expenses for yourself, your spouse or your children or grandchildren.
When it comes to health concerns, you may take early withdrawals if you are totally or permanently disabled. In addition, you can tap into your retirement funds to cover medical expenses that add up to more than 7.5 percent of your adjusted gross income. Only deductible medical expenses paid in the year the distribution is taken qualify for the exception.
You can also take a penalty-free early distribution for health insurance premiums if you are unemployed, have received unemployment compensation for at least 12 consecutive weeks and have taken the distributions during the same year in which the unemployment compensation is made, or the succeeding year. These payments, however, are limited to the actual amount paid for insurance for the employee, his spouse and their dependents.
Self-employed taxpayers qualify for this exemption if self-employment is the only reason they do not qualify for unemployment compensation.
Generally, if you need money in a pinch, it’s best to draw first from your emergency funds or from any investments that you have. If you don’t have a nest egg available and are seriously considering withdrawing from a retirement account, given the complexity of the rules on retirement plan withdrawals, be sure to turn to your local CPA. He or she can provide advice on all your financial questions.
Copyright 2012 American Institute of Certified Public Accountants.
The Money Management columns are a joint effort of the AICPA and the California Society of CPAs as part of the profession’s nationwide 360 Degrees of Financial Literacy program.
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