People who are facing difficult financial times, such as a job loss or other income reduction, may turn to any available source of cash to help them meet their living expenses. Often, retirement accounts are an easy target. It may not be wise to withdraw money from these accounts early -- not only do you lose the benefit of the money growing over time, but the taxes and penalties significantly reduce your nest egg.
Early Withdrawal Penalty
Retirement accounts are intended to save over the long term so that you have an established nest-egg to use during your retirement to pay for your living expenses. To discourage early withdrawals, the IRS imposes a significant penalty for withdrawals that you take from retirement plans before you reach retirement age. Usually, the tax penalty is 10 percent of the amount withdrawn if you are under age 59 1/2.
Taxed as Normal Income
While many investments are taxes at the capital gains rate, which can be as low as 0 percent in some cases, withdrawals from most retirement accounts are taxed at the rate for normal income, the same as what you pay on your earnings from salary. Since the amount you withdraw is added to your income for the year, you may end up in a higher tax bracket, resulting in even more tax liability for the retirement withdrawals.
If you live in a state with an income tax, the state will also be in line for its portion of the withdrawals. While your state does not impose a separate early withdrawal penalty like the federal 10 percent penalty, it will add the early withdrawal to the taxable income of the taxpayer for the year. State taxes will be imposed on that amount, resulting in a greater erosion of the withdrawn money.
Roth IRA contributions may be withdrawn at any time, without a tax penalty. In addition, Roth contributions are not subject to federal or state income tax when withdrawn. Roth earnings may be taxed and have penalties for early withdrawal depending on how long the account has been open. Traditional IRA withdrawals can be taken penalty-free to pay medical expenses that exceed 7.5 percent of your gross income, or to pay for college for an immediate family member. Taxpayers may also withdraw up to $10,000 without penalties for a down payment on a first home.