If you planned to retire in 5 years, but have hit hard times, you may be tempted to dip into one of your retirement plan accounts. Don't unduly damage your retirement plan by randomly grabbing a distribution.
Qualified retirement plans such as the 401(k), 403(b), 457, and an IRAs offer tax-deferred compounding of your savings which helps them grow faster than accounts where savings are taxed annually. They're funded with tax-deductible contributions so any distributions from them are taxed as ordinary income (up to 35% tax, plus State).
As an incentive to keep your savings in these retirement plans, the IRS penalizes early withdrawals too. So income and penalty taxes cut out a chunk of what you withdraw. And you lose future tax-deferred growth of that money. So know the distribution rules and exceptions.
Qualified retirement plans – including IRAs impose the 10% penalty on all withdrawals before your reach 59½. And of course all distributions are taxed as ordinary income.
Now for the exceptions to the penalty tax – but not the income tax!
1) A distribution of your entire benefit under a 401(k) plan that is made after separation from service and age 55 is not subject to the 10% tax.
2) Most any qualified retirement plan has some kind of 'hardship' withdrawals that are not penalized. Examples of these are:
• Distributions made because you are totally and permanently disabled.
• Distributions made as part of a series of substantially equal periodic payments over the life expectancy of the owner.
• Distributions that are equal to or less than your deductible medical expenses - i.e. the amount of your medical expenses are more than 7.5% of your adjusted gross income. You do not have to itemize to meet this exception.
Retirement plans also allow these other penalty-free withdrawals:
Health insurance premiums
Penalty-free withdrawals can be taken from an IRA (not a qualified retirement plan) if you're unemployed and the money is used to pay health insurance premiums. The caveat is that you must be unemployed for at least twelve weeks.
Death
Death would seem to be the ultimate hardship and when an IRA or retirement plan account holder dies, the beneficiaries can take withdrawals from the account without paying the 10 percent penalty, regardless of the beneficiary's age.
If you owe the IRS
You can use IRA funds penalty-free to pay unpaid federal income tax
Homebuyers
Take the down-payment money from your IRA, and it's penalty-free (not true of withdrawals from other retirement plans). The penalty-free withdrawal is not limited to first-timers either as homebuyers must not have owned a home in the previous two years, though. Further you can take more than one penalty-free withdrawal to buy a home, but there is a $10,000 limit, which won't do you much good in many parts of the US.
Temporary withdraws from retirement plans that are tax-free:
You can get a loan from your 401(k) if you remain working for that employer. Additionally,
rolling over your IRA yourself allows you 60 days use of your money, an IRA loan, before you must transfer the full amount you withdrew into a new IRA. Note that not all 401K retirement plans allow you to take 'in service' withdrawals while still working for the employer.
It's probably better to borrow money outside your retirement plan if you can.
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The caveat is that you must be unemployed for at least twelve weeks. -
One of the keys to not dipping into your retirement savings is to do something we Americans mostly find very difficult - cut back. Scale back a bit on your lifestyle, just enough to ensure that your savings remain that - your savings. It's tough to swallow, but you'll be so glad later down the line.
Nowadays, it's very hard to retire unless you have earn a colossal amount of money before.
Moreover if IRS penalizes early withdrawals... we will never retire ^^