The Implications of Early Retirement Plan Withdrawals

As pension plans go by the wayside, Americans are increasingly becoming responsible to put money away for retirement in a 401k or IRA plan. Typically, the goal is to not touch this money until you retire, but sometimes individuals will take early withdrawals. So what qualifies as an early withdrawal? An early withdrawal normally means taking money from your plan before you reach age 59 ½. If you made an early withdrawal from your retirement plan last year, you must report the amount you withdrew to the IRS on your tax return. Beware that you may have to pay income tax on that amount as well as an additional 10 percent tax on the amount. The 10 percent additional tax won’t apply to nontaxable withdrawals. Nontaxable withdrawals are those that include contributions that you paid tax on before you put them into the plan. There are also other exceptions, which the IRS details. If the penalties for early withdrawal don’t encourage you to keep your money in your retirement fund or plan, maybe the benefits of compound interest will. Compound interest occurs when the interest that accrues to a principal amount of money begins to accrue interest itself. J.P. Morgan in their 2014 “Guide to Retirement” presents the following graph that demonstrates this profound concept. Susan, Bill, and Chris invest different amounts at different ages and for different lengths of time. Susan invests for 20 fewer years than Bill does, but because Susan invested a decade before Bill started, she ends up with more money than Bill does when they retire.

Still not convinced to keep your money in your retirement fund? If you do end up making an early withdrawal, you may need to file Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts, with your federal tax return. As tax returns are complicated, the best advice is to consult your tax preparer or financial adviser. More information on this topic is also available on IRS.gov.