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Why You Should Not Take Early Retirement Withdrawals

Why You Should Not Take Early Retirement Withdrawals

| January 17, 2022
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When money gets tight, it can be tempting to think about your retirement accounts as a potential source of financial help. However, an early withdrawal from your retirement account may be costly. Learn more about the taxes, fees, and penalties that may come from an early retirement withdrawal, as well as some factors to consider when your options are limited.

How Much Do Early Withdrawals Cost?

Because of the preferential tax treatment retirement contributions receive, early withdrawals are penalized and taxed. If you withdraw money from a tax-deferred retirement plan before you reach age 59 and-a-half, you must pay a withdrawal penalty of 10% plus ordinary income tax on the withdrawn amount.

Post-tax retirement plans like Roth IRAs allow early withdrawals of contributions, though an early withdrawal of gains is also subject to a 10% penalty. The more money you withdraw, the larger your tax bill and penalty.

For example, if your tax rate is 33%, you must pay a 10% penalty plus 33% for income taxes, which is a total of 43% taken from an early distribution. In this example, taking out $10,000 from a retirement account will net you only $5,700.

Exceptions to the Early Withdrawal Penalty

Not every early withdrawal is subject to this penalty. However, all early withdrawals from tax-deferred accounts will be subject to income taxes. Without paying a penalty, first-time homebuyers can withdraw up to $10,000 from a traditional individual retirement account (IRA) for a home purchase. Unemployed individuals may withdraw the $10,000 to pay for health insurance.

Another example of an exception is that 401(k) account holders may avoid a penalty by waiting to withdraw funds until age 55 or older as long as they are retired, unemployed or using the funds to pay medical bills.

Hidden Costs: Opportunity Cost

One cost of early retirement withdrawals that is not as apparent is the opportunity cost of reducing your retirement account balance. The time value of money is one of the most powerful influences on your future account balance. Every dollar you withdraw from a retirement account now could have grown to more by the time you retire if you left it in the account to compound.

Here is an example used to demonstrate the calculations. Your results may be quite different.

Suppose a $10,000 retirement account earns an 8.3% rate of return. This account may grow to $35,000 in 30 years, even with no additional contributions. Withdrawing $2,000 from this account and leaving the remaining $8,000 to grow at the same 8.3% rate of return means you end up with only $28,000 at the end of the same period. When spread over time, this $2,000 withdrawal reduces the retirement funds balance by $7,000.2

Consider your time horizon whenever you think about withdrawing from a retirement account. Generally, the younger you are and the smaller your total retirement account balance, the greater the impact an early withdrawal might have on your future fund’s balance.

Important Disclosures

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual security. To determine which investment(s) may be appropriate for you, consult your financial professional prior to investing.

Investing involves risks including possible loss of principal.

Contributions to a traditional IRA may be tax deductible in the contribution year, with current income tax due at withdrawal.  Withdrawals prior to age 59 ½ may result in a 10% IRS penalty tax in addition to current income tax.

The Roth IRA offers tax deferral on any earnings in the account. Withdrawals from the account may be tax free, as long as they are considered qualified. Limitations and restrictions may apply. Withdrawals prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Future tax laws can change at any time and may impact the benefits of Roth IRAs. Their tax treatment may change.

This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.

All information is believed to be from reliable sources; however LPL Financial makes no representation as to its completeness or accuracy.

 

Sources

https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-tax-on-early-distributions

http://www.fncalculator.com/financialcalculator?type=roiCalculator

 

Content Provider: WriterAccess

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