Retirement plans, such as 401(k) plans and individual retirement accounts (IRAs), are structured to allow investors save money while they are working in order to have money in their retirement. Although it is possible to withdraw funds early from most of these plans, it is often financially punitive to do so.
Types of Retirement Plans
There are many types of tax-advantaged retirement plans structured by the Internal Revenue Service. The two most common types are employer-sponsored 401(k) plans and IRAs. With 401(k) plans, the employee, the employer, or both contribute to the plan. With an IRA, the investor is responsible for all of the contributions. These plans can be further divided into traditional and Roth plans. Each type of plan has different tax consequences for both contributions and withdrawals.
Traditional 401(k) plans and traditional IRAs allow contributions on a pretax basis. This means that in a 401(k) the employer does not withhold income taxes on the portion of the employee's gross wages that go into the plan. In an IRA, taxpayers get a deduction on their income tax returns for their eligible contributions. When it comes time to withdraw funds from these plans, the entire withdrawal is taxable as ordinary income. If you withdraw funds from a traditional plan before you turn 59 1/2 years old, you are also subject to a 10 percent non-recoverable penalty on amounts withdrawn.
A Roth 401(k) and a Roth IRA allow you to contribute retirement funds to the plan on an after-tax basis. This means that you do not get a tax break on the contributions. However, when you withdraw the funds, you do not pay income tax on any of the withdrawal, including the income portion. However, if you withdraw from a Roth plan before you turn 59 1/2, the rules are complex. The IRS requires that you withdraw in a certain order. You may withdraw up to the total amount contributed to the plan without tax or penalties. You are considered to be withdrawing from this pool first. If you withdraw any earnings in the plan early, you are subject to income tax at your marginal rate, and a 10 percent penalty on that portion.
The IRS allows for some exceptions to the 10 percent penalty for early withdrawal in situations of hardship. These include unreimbursed medical expenses, disability or death of the plan holder, the purchase of a first home, and certain educational expenses. These amounts are still subject to tax.
- Comstock/Comstock/Getty Images