Editor’s Note: Over the next few weeks, Smart Balance Transfers will be running a series of articles on common tax questions answered by professionals from H&R Block. We will also be giving away six free copies of H&R Block’s premium home tax software, valued at $55. If you’d like a free copy, contact us and simply let us know what you like or don’t like about our website. If your comment is helpful, we’ll get back to you with a free code.
Today’s article stems from a Q&A with Leigh Mutert of H&R Block on the cost of early 401k withdrawal.
Q: “I know there is a 10% early withdrawal fee if I take money out of my traditional IRA, but how much will the tax be on this withdrawal?”
A: “There is not a tax on the IRA withdrawal itself. However, you must include the amount withdrawn as income on your taxes, so the affect this withdrawal will have on the taxes you owe depends on your current tax situation. Adding this to your income may have an impact on the tax bracket you fall into and the tax you pay. H&R Block has a wonderful Tax Estimate Calculator to estimate your refund or balance due.” -Drennon Stringer, Senior Tax Advisor 1, Small Business/Sole Proprietors, H&R Block
Withdrawing Funds Early From 401(k), 403(b) and IRA Plans
401(k), 403(b) Plans
These plans let you save for retirement while deferring income taxes on the saved money and earnings until withdrawal. Many employers offer 401(k) plans to which you can contribute a percentage of each paycheck, and many even match up to a certain percentage of your contribution.
If your retirement plan is a section 401(k) or section 403(b), you may be able to get your money early if you face financial hardship. To qualify for a hardship withdrawal, you must prove the following:
• You have an immediate financial need such as medical bills, a down payment on a home or a rent payment to avoid being evicted.
• You don’t have savings and you’re unable to borrow from a bank.
The early distribution penalty applies only to taxable amounts. It doesn’t apply to amounts rolled over or amounts that are allocated to after-tax investments in the plan or IRA.
Exceptions to the early withdrawal penalty from a 401(k) or 403(b)
• You are totally and permanently disabled.
• To the extent you have medical expenses that are more than 7.5% or your adjusted gross income.
• You receive money from the plan after you separate from the service of your employer during or after the year in which you reach age 55 (age 50 for qualified public service employees).
For a complete list of exceptions, see Form 5329.
Note: Any withdrawals you make will reduce the funds you have available at retirement. The IRS may also impose other restrictions. Even if your retirement plan permits hardship withdrawals, distributions received before age 59½ are generally subject to the 10% early distribution penalty.
Individual Retirement Account (IRA)
An IRA is a retirement plan account that provides some tax advantages for retirement savings. There are a number of different types of IRAs, which may be either employer-provided or self-provided plans.
• Traditional IRA contributions are often tax-deductible, and all transactions and earnings within the IRA have no tax impact. Withdrawals at retirement are taxed as ordinary income (except for the portion of the distribution attributable to nondeductible contributions). Owners must begin taking distributions by April 1 of the year after reaching age 70½.
• Roth IRA contributions are made with after-tax funds. All transactions within the IRA have no tax impact, and qualified withdrawals are tax-free. Distributions are not required beginning at age 70½, so a Roth IRA may allow you to pass on more to your heirs.
The maximum annual IRA contribution for 2010 is $5,000 if you’re younger than 50. Individuals age 50 or older can contribute up to $6,000.
Withdrawing from an IRA
You can take money out of a traditional IRA at any time, but if you take it out before age 59½, you generally will have to pay a 10% early distribution penalty in addition to income tax.
Exceptions to the penalty include:
• Up to $10,000 used to purchase a first home.
• Up to the amount of qualified higher education expenses.
• Amounts for medical expenses that exceed 7.5% of your adjusted gross income (even if you don’t itemize), amounts up to the amount of your medical insurance premiums if you received unemployment compensation for at least 12 consecutive weeks.
• Amounts you withdrew because of permanent and total disability. See IRS Publication 590 for more detail about these exceptions.
H&R Block has online and desktop software makes it easy to file your taxes from home, or you can find an H&R Block office near you. To get a free copy, take a moment to evaluate our site and let us know how we can make it better.
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