Tax-deferred retirement plans can help you prepare for your future needs by properly funding your retirement. That’s why 401k and other employer provided plans are popular, and why individuals like to set up their own retirement plans in the form of IRAs. Of course, you are supposed to leave money in the retirement account until you retire. If you don’t, you will have to pay taxes on it and some stiff penalties as well.
Retirement Plan Basics
The IRS sets 59 1/2 as the age at which you can begin taking distributions from retirement plans. The funds in an account are not taxed until you withdraw them and your contributions to a plan may or may not be tax deductible, depending on the plan rules. If you have an IRA of any kind, you can withdraw funds early. This may not be the case with an employer provided plan. Allowing early withdrawals is up to the plan provider, and the terms are stated in the plan agreement.
Taxes and Penalty
When you withdraw funds from a retirement plan early, the money is subject to ordinary income taxes in the year the withdrawal takes place. In addition, the IRS normally imposes an additional 10 percent of the amount withdrawn as a penalty. The penalty does not apply to funds rolled over into another retirement account, if the money is in the new account within 60 days of being removed from the original account. In some cases you may have to pay ordinary income taxes on money rolled over into another account. For example, this is usually the case if you move funds from a 401k to a Roth IRA.
Sometimes contributions to a retirement plan are not tax deductible. This is true for contributions to a Roth IRA. Because you have already paid taxes on nondeductible contributions, there is no further tax liability. In general, you can take nondeductible funds out of a retirement plan at any time without incurring any tax liability or penalty.
There are some exceptions the IRS allows for penalty free early withdrawal, although you will generally still have to pay ordinary income taxes. Again, these options may not be available with some employer provided plans. You can take funds out to pay for a first home or for certain higher education expenses. If you become permanently disabled, withdrawal does not incur the 10 percent penalty. Paying medical expenses that are not covered by health insurance or health insurance premiums while you are unemployed are also allowed as exceptions. You may take out only enough to pay for the specific expenses plus applicable taxes.