It can be tempting to take money out of your retirement account for an unexpected expense. But tapping into your retirement savings before you actually retire can put your financial security at risk. Here’s how.
You may need to pay an additional 10% in taxes.
Icon is an Individual Retirement Account (IRA), tax-advantaged retirement savings account regulated by the IRS. By law you can take money out at any time. However, the amount you take out will be included in your taxable income, and you’ll have to pay an additional 10% tax if you’re under age 59 1/2. That tax penalty is in addition to your normal federal and state income taxes.
There are notable exceptions to this rule.
There are multiple cases when you are exempted from paying penalties for early withdrawals. To be exempt from paying that additional tax, you must qualify for one of the following and complete IRS Form 5329:
- Medical expenses that will not be reimbursed
- Permanent disability
- Beneficiary disbursements
- Qualified higher education costs
- First home costs
- IRS levy
- Qualified reservist early distribution
If your distribution falls into one of these categories, talk to a tax professional and be sure to use IRS Form 5329. The IRS provides more details here.
Why do I have to pay a tax penalty on money?
You may be wondering why you must pay an early withdrawal penalty on money that is rightfully yours. Well, the IRS provides you with tax benefits associated with retirement plans. As part of the agreement to provide you with these tax benefits, the IRS wants to ensure you keep the money in your retirement account unless it is absolutely necessary to remove it.
The less money in your account, the less it grows
Not only do you reduce your savings in your retirement account by the amount you withdraw, but you also cause the savings you leave in to grow at a slower rate. Why? Compound interest. If the market grows at 8% per year, and you have $100,000 in your account, you earn $8,000 in interest that first year and $8,640 in interest the year after (without adding any additional money), because you’re earning interest on your interest.
Conversely, let’s look at what happens if you take money out of your account in the second year. If you started the year with $108,000 ($100,000 + $8,000 interest), and take out $10,000, you’re left with $98,000. On which you’ll earn $7,840 in interest. That’s almost $1,000 in fewer earnings in one year. Compound that over the life of your account and that equals a significant loss in savings.