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Sound financial planning is saving for your retirement so that you can continue to enjoy the same lifestyle. However, sometimes we need to withdraw the funds from our 401k or IRA due to life circumstances. Read this guide by H&R Block to know the consequences of early encashment of 401k or traditional IRA.

Consequences of Early Encashment of 401(K) or Traditional IRA

Last Update Date : June 26, 2018

early encashment of 401k

The comfort and security of growing old with the one you love, is a dream many have. While, it is a blessing to be lucky in love and grow old with your love, the quality of life you and your loved one have during your golden years should be well planned. As you and your spouse grow old together, so can your 401(k) or IRA. However, life can throw uncertainties your way, which may require you to withdraw your retirement savings, which can have penalties. Let’s discuss the risks of early encashment of 401(k) or IRA.

Withdrawal Rules and Penalties

Many people have some form of retirement savings plans, such as 401(K) or Individual Retirement Account(IRA). The best benefit of these retirements plans is the tax deductions on the contributions.

While the age for retirement is 59 ½ , those who retire at the age of 55 can also withdraw their funds without facing penalties as well as those in public safety can retire as early as 50 years and withdraw the funds. At the age of retirement and withdrawal of these funds, they are taxed, but as many are in a lower tax bracket, the tax liability is significantly less. However, these tax benefits are only applicable if all the rules of the plans are followed. If for any reason, a person was to withdraw these funds prematurely, then the penalties levied are heavy.

If your 401(K) is withdrawn before the age of 59 ½ then the amount withdrawn will not only attract tax, but there is an 10% additional penalty imposed on the withdrawn amount. So, for example, as shown below, if a person at the age of 35, was to withdraw $50,000 of their 401(K) or IRA, then the amount of taxes that are cut is almost half at $21,000.

penalties for early encashment of 401kYou not only lose a major chunk of your savings to taxes, but your retirement funds shrink considerably, which may result in difficulties during your retirement.

Penalty Free Withdrawal Exceptions

Under circumstances, there are provisions for premature withdrawal without penalties, which are listed below:

Education

If you, your spouse, children or grandchildren, wish to pursue higher education, then you can qualify to take an IRA distribution. The amount withdrawn to pay for tuition, books, etc., will be taxed as normal income, but there will be no extra penalty.

Purchase of First Home

As per the IRS, a first home buyer is loosely defined as a person has not held ownership interest for the past two years. You can withdraw up to $10,000 of your IRA without attracting any penalties, towards the purchase of your first home. This option can again be availed by your spouse, children, parents etc., even if you, yourself have previously used this option towards the purchase of your first home.

Cover Medical Expenses

If you are unable to get reimbursed for your medical expenses and the expenses equal to more than 10% of your adjusted gross income for the relevant year, then you can withdraw them from you IRA without facing any penalties.

Annuity

By opting for 72T of the IRS tax code, you can take a “Series of Substantially Equal Periodic Payments” from your IRA without penalties levied. This means that you will receive continuous payments for, the longer of, five years or until you reach 59 ½ years of age. But the drawback to this is that you have to take the calculated distribution amount for the entire duration, even if the money is no longer needed.

Other Penalty Free Options

401k Loan

With the permission of your employer, you can borrow up to the lesser of, $50,000 or half of your 401(K). The borrowing interest rate is a few points above the prime rate. You pay the interest and principle to yourself and they get deducted out of your salary, monthly. The term is normally five years, but if the borrowed amount is for the purpose of securing a down payment on place of residence, then the term can be extended for up to fifteen years.

The best and most obvious benefit to this is, since you are borrowing from yourself, there is no credit check and nothing appears on your credit report. The interest, which is usually lower than the market rate, is paid to yourself. However, the drawback is that if you change jobs or you are fired, your loan amount will be due immediately (within 60-90 days) and if you are unable to pay it back, then the IRS will issue a penalty. Additionally, your retirement funds get depleted.

IRA Rollover

If you are in need of immediate cash for a short duration, then you can choose to roll-over the amount into a new IRA. The new account must have the rolled over amount within 60 days and during this interim period, the money is free for you to use as you wish. However, at the end of 60 days, the amount must be deposited into the new account else the IRS will see it is an early withdrawal and all penalties and taxes will be applicable.

Best to Not Withdraw

While, there are options available to you, when you are in a financial crisis to utilize your retirements savings, it is best not to withdraw prematurely, as not only do you face taxes and penalties, but your retirement future is also at risk. So, if faced with life’s difficult situations, instead of dipping into your 401(K) or IRA, explore other options, such as loans or invest in other low-cost funds, which you can access during emergency situations.

How H&R Block Can Help You?

Growing old with your loved one and enjoying your golden years in comfort is a blessing, which should not be ignored or taken for granted. Diversify your investment options wisely and for maximizing your tax savings and expert tax planning, enlist the aid of your personal tax expert at H&R Block India.

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