You might consider tapping into your retirement plan early to get some needed funds if you've faced illness, job loss or other hardship due to the COVID-19 pandemic. Doing so usually means paying an extra tax penalty along with any taxes due on the withdrawn money. But the Coronavirus Aid, Relief and Economic Security Act, passed in March 2020, introduced some leniency for early withdrawals when they're related to hardships from the coronavirus.
Read on to learn what you should know about the financial consequences of taking early retirement plan withdrawals and implications on your taxes.
Retirement Plan Tax Basics
Some of the most common retirement plans include 401(k)s, Roth IRAs and traditional IRA accounts. They all allow both you and your employer to contribute funds up to set annual limits. You must keep your money in the account until you reach age 59½ or you'll have to pay a tax penalty except in some specific situations.
You must take required minimum distributions or withdrawals once you reach age 70 1/2, or age 72 if you were born after June 30, 1949. You'll also face tax penalties if you fail to do so. Roth plans are an exception to this RMD rule.
Roth plans differ from traditional plans in terms of the tax treatment of contributed and withdrawn funds:
- You exclude your contributions from your taxable income now and instead pay income taxes on that money upon withdrawal with a traditional IRA. This works the same for many traditional 401(k) plans.
- Roth IRA plans and Roth 401(k) plans involve paying taxes now on contributed funds so you don't have to do so when you withdraw the money later. These Roth accounts will lead to income taxes, however, if you withdraw earnings on contributions early or if you make any withdrawals before you've held the account for at least five years.
Read More: Why Is it Important to Invest Money for Retirement?
Typical Early Retirement Withdrawal Rules
You'll face a 10-percent early withdrawal penalty for traditional IRA or 401(k) withdrawals – on top of the taxes due on the distribution – if you're not at least age 59 1/2 when you take them. Qualified early withdrawals from Roth retirement accounts don't incur the 10-percent penalty because you pay taxes on your contributed Roth IRA or 401(k) funds in the tax year in which you made them.
The good news is that the IRS allows for various exceptions to this rule, even when there's no pandemic. You can avoid the penalty if you face a qualified hardship or perform specific actions with the money. These can vary by type of plan.
Death, total disability, significant medical expenses and plan rollovers lead to no penalty for either 401(k) and IRA owners. IRA owners can additionally get exceptions for educational expenses, first-time home purchases and health insurance premium reimbursement if they're unemployed. You'll have to show an immediate financial hardship to qualify under some conditions.
The Coronavirus and Early Withdrawals
The CARES Act provides that you can avoid the 10-percent penalty on traditional IRA and 401(k) withdrawals through some COVID-19 exemptions as well. Eligibility factors include you or an immediate family member having a positive COVID test, as well as a provision for those who have faced adverse financial consequences through events like having to quarantine, losing your job, or not having childcare due to school closures and similar causes. IRS Notice 2020-50 offers a full rundown of COVID-19 hardships that qualify.
You could take out as much as $100,000 from your retirement plans early without the penalty in 2020 if you qualified. This is a total limit, so you could pull those funds from multiple retirement accounts if necessary. But you had to take the withdrawals between Jan. 1 and Dec. 30, 2020 to qualify under the CARES Act provisions.
What to Expect With Taxes
Money taken from your retirement account early usually qualifies as income that's subject to taxation unless you've only withdrawn contributed funds from a Roth account. This means that you must report this amount alongside regular employment and self-employment income on your tax return to calculate your taxable income and taxes due for the year. Those extra funds could send you into a higher tax bracket and you would owe additional taxes as a result.
But the CARES Act has your back here, too. It allows for more lenience when it comes to paying back the withdrawn money and avoiding taxation on COVID-related early retirement plan distributions. Rather than report the distributions in full on the 2020 tax return you filed in 2021, you can spread the withdrawals over three tax years. And you can recontribute retirement plan funds over those three years to avoid taxes on them altogether.
Keep in mind that you'll end up paying the 10-percent penalty and extra income taxes when you report the distributions on your next return if your retirement plan withdrawal wasn't due to the coronavirus or another qualified hardship under IRS rules, You can use this calculator to determine how an early withdrawal can impact you financially in this situation.
And you must include this income on your 2021 and 2022 tax returns (filed in 2022 and 2023) if you don't recontribute the money.
Taking Early Retirement Plan Withdrawals
You had only a narrow window to take advantage of the terms of the CARES Act: tax year 2020. The waiver of penalties did not extend into 2021 or 2022. Consider whether you have any other options for getting the money if you missed the window.
Contact your plan administrator to ensure that early withdrawals are permitted, especially if you're dealing with a 401(k) account. You may only have access to a certain amount of vested funds in such accounts. It's also worth talking to an accountant or financial advisor about the future tax implications of the withdrawal to do some tax planning.
You can then expect to either complete a paper withdrawal request form or log in to your retirement plan management website to request the funds. Be prepared to give a reason for the early withdrawal request. Specify how you'd like to receive the money, such as by check, electronic funds transfer or a rollover. Note whether you'd like taxes withheld now.
- IRS: Publication 590-B (2020), Distributions from Individual Retirement Arrangements (IRAs)
- IRS: Retirement Topics - Exceptions to Tax on Early Distributions
- IRS: Retirement Topics - Hardship Distributions
- Consumer Financial Protection Bureau: Considering an Early Retirement Withdrawal? CARES Act Rules and What You Should Know.
- IRS: Coronavirus-Related Relief for Retirement Plans and IRAs Questions and Answers
- TIAA: The CARES Act Stimulus Package Offers Some Relief From the Economic Effects of Coronavirus
- Forbes: How the CARES Act Eases Retirement Account Rules During COVID-19
- U.S. Securities and Exchange Commission: COVID-19 Related Early Withdrawals from Retirement Accounts—Be Careful of Fraudsters and other Bad Actors Targeting Your Retirement Savings
- IRS: Guidance for Coronavirus-Related Distributions and Loans from Retirement Plans Under the CARES Act
- TIAA: Early Withdrawal Calculator
- SoFi: Understanding the Different Types of Retirement Plans
- Fidelity: Request a Check
- IRS: 2020 Instructions for Form 8915-E
- IRS: Retirement Topics – Required Minimum Distributions (RMDs)
- AARP: What Every Retirement Saver Needs to Know About 2022
Ashley Donohoe has written about business and technology topics since 2010. Having a Master of Business Administration degree, bookkeeping certification and experience running a small business and doing tax returns, she is knowledgeable about the tax issues individuals and businesses face. Other places featuring her business writing include Zacks, JobHero, LoveToKnow, Bizfluent, Chron and Study.com.