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What to consider when making early withdrawals from retirement funds

Posted on November 8, 2022

Unexpected financial hits can occur – even with the best planning. To cover these costs, its tempting to withdraw funds early from your retirement savings.

While this may seem like an easy way to get cash quick, early withdrawals generally come with heavy penalties and costly tax consequences.

Here’s what to know before you dip into hard-earned retirement savings:

Workplace retirement plans: 401(k), 403(b) and 457(b)
These plans can distribute benefits only when certain events occur. Your plan’s summary description will clearly state if it allows hardship distributions, early withdrawals or loans.

  • Hardship distributions are withdrawals from a participant’s account made because of an immediate and heavy financial need and it’s limited to the amount necessary to satisfy that financial need.
  • Hardship distributions are includible in gross income unless they consist of designated Roth contributions.
  • Distributions before the participant turns 65, or the plan’s normal retirement age, if earlier, may result in an additional income tax of 10% of the amount withdrawn.
  • Important: Repaying hardship distributions back to the plan or rolling it over to another plan or IRA isn’t permitted.
  • Borrowers should review the limits on loan amounts and other requirements. Taxes on this money don’t occur if the loan meets the rules and repayment happens on schedule.

Required minimum distributions
Taxpayers must make required minimum distributions each year beginning with the year the taxpayer turns 72, 70 ½ if the taxpayer turned 70 ½ in 2019. People calculate the RMD by dividing the IRA account balance as of December 31 of the prior year by the applicable distribution period or life expectancy. RMDs are waived for 2020 due to COVID-19 relief provisions. Required minimum distributions are not required for Roth IRAs.

IRAs and IRA-based plans
Individuals may take distributions from their IRA, SEP-IRA or SIMPLE-IRA at any time. Taxpayers do not need to show a hardship to take a distribution – they can just contact the financial institution managing the account.

Coronavirus-related distributions and loans 
The CARES Act made it easier to access savings in IRAs and workplace retirement plans if you were affected by the coronavirus.

  • Certain distributions made from Jan. 1, 2020, through Dec. 30, 2020, from IRAs or workplace retirement plans to qualified individualsmay be treated as coronavirus-related distributions.
  • These distributions aren’t subject to the 10% additional tax on early distributions, including the 25% additional tax on certain SIMPLE IRA distributions.
  • Repayment to an IRA or workplace retirement plan can occur within three years.

Taxpayers can include Coronavirus-related distributions in income over 3 years, one-third each year, or if elected, in the year of the distribution.

Divorce-related distributions
Early distributions may also be taken from a traditional IRA to satisfy a divorce requirements or court order.  They are subject to regular income tax requirements and the 10% additional tax unless there is a qualifying exception.

Thankfully, you have experts on your side if you have questions. Call the friendly and knowledgeable CPA at Teipen CPA Group. We can help.