If you have an urgent situation – educational expenses, medical bills, a new house – it’s tempting to take an early withdrawal from your retirement account. But, before you do, think about the true impact the decision will have on your finances. What happens when you take money out of your 401(k), IRA, or other retirement account before you reach age 59 ½?
An early distribution from a retirement account is generally taxable as income in the year that the distribution is taken. The exception is a Roth IRA – with a Roth, money contributed is not taxed, but gains that are withdrawn are taxed.
In addition to paying income tax on an early distribution from your retirement account, you’ll also pay a 10% penalty to the IRS. This is unless the distribution falls into one of several exceptions the IRS has designated as penalty free. These exceptions include college tuition expenses, certain medical expenses, and the purchase of a first home. Even if you avoid paying a penalty, though, income tax still applies.
Loss of Potential Wealth
Perhaps the biggest cost of withdrawing money early from your retirement account is the loss of potential wealth. Depending on the amount of the distribution, taking money out of your account years ahead of schedule can result in thousands – or even hundreds of thousands – of dollars in lost retirement funds.