I Lost My Job. Can I Tap Retirement Accounts Without Penalties?

I lost my job last year and need to take care of a parent. In doing that, I must withdraw money from my retirement. I don’t understand the tax implications and penalties. I would also like access to any savings I have without restrictions or penalties. When I start my new job, what should I invest in going forward? I do not want another situation that comes up where the only way I can get my money is to take a huge penalty. The bulk of my money is in a traditional IRA and there’s a little in a Roth.

I’m sorry to hear that you’re dealing with these struggles and glad you asked about the best way to manage your retirement account withdrawals. Doing this the right way can help minimize your tax burden. That is especially important when preserving resources is crucial.

Most financial advisors caution against pulling money out of retirement accounts before retirement age. But when that’s the only way you can meet your essential expenses, such as housing, food and medicine, without getting buried in high-interest debt, it’s the right move. And you’ll want to do it in the most tax-efficient way.

Though you own the money in your retirement accounts, withdrawals before the official retirement age are restricted. The rules can be complicated but having a solid understanding of them can help you avoid paying IRS penalties.

In most cases, taking early distributions from retirement accounts will result in your getting less money than you need unless you account for the taxes and penalties. For example, say you need $10,000. Between the 10% early withdrawal penalty and the average 25% for federal and state income taxes, you may end up with only $6,500 cash in hand. To end up with the full $10,000, you’ll need to withdraw more than that from your retirement account.

I strongly advise working with a financial advisor or tax advisor when you’re working through this. They know strategies to minimize the taxes and penalties on your withdrawals and may have suggestions for other resources you could tap into.

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Here’s what you need to know about the consequences of premature retirement distributions and potential ways to limit the damage.

A financial advisor may help you understand the impacts of your investment and income decisions.

Taking Money From a Traditional IRA

The general rule for traditional individual retirement accounts (IRAs) is this: If you take money before you reach age 59 1/2, you’ll pay regular income taxes on the withdrawal plus a 10% penalty. But there are some exceptions where you can avoid that extra 10% hit. Those include:

• Health insurance premiums you pay while you’re unemployed

• Complete and permanent disability

• Unreimbursed medical expenses in excess of 7.5% of your adjusted gross income (AGI)

• Up to $10,000 for a first-time home purchase

• Qualified higher education expenses

If any of the exceptions apply to you, you’ll report them on IRS Form 5329 when you file your income tax return.

If you’re really strapped for cash, you can elect to not have any taxes withheld, but that could leave you with an unmanageable tax bill when you file your return.

Withdrawing From Your 401(k)

The process for early 401(k) withdrawals adds an extra layer to deal with: your employer’s rules. In most cases, if you’ve separated from your employer for any reason, you won’t be able to access your money until you hit retirement age. That’s true unless you roll over the account into an IRA. Once you do that, the regular traditional IRA rules will apply.

While you’re still working at the job with the 401(k), your employer decides whether you can take early withdrawals or borrow money from your account. That information should be included in the plan documents. Alternatively, you can check in with the human resources or payroll departments to find out if either option is available. If you can take money out, you’ll have to decide which options make more sense for you.

Taking a Loan From Your 401(k)

Borrowing from your 401(k) seems like the hands-down better option, but it does come with some drawbacks. On the plus side, a loan doesn’t have any tax impact and you’ll pay yourself back with interest. That can help rebuild your retirement savings at least a little.

On the downside:

• Loan repayments usually get automatically deducted from your paycheck, reducing your take-home pay.

• Payments usually start with the very next check, which will impact your current cash flow when you’re already struggling.

• Most employers won’t let you make any contributions while you have a loan outstanding.

• If you leave your job for any reason, including getting fired or laid off, you have to pay the loan back in full right away. If you can’t, it will be treated like an early withdrawal, subject to taxes and the 10% penalty.

Taking an Early Withdrawal From Your 401(k)

If your employer allows early withdrawals, the money you take out will be subject to withholding taxes and penalties, just like an IRA withdrawal.

Also, be aware that the hardship withdrawal rules are slightly different for 401(k) plans. First, you can only take out your contributions and employer matches, but not any account earnings. Second, there are fewer exceptions to the 10% penalty than there are for IRAs.

Withdrawing From Your Roth IRA

With Roth IRAs, you’ve already paid taxes on the money you contributed, so that money is yours to withdraw at any time. But the rules for any earnings that have accumulated in your Roth – dividend income, for example – come with strings attached. If you pull out any amount more than you put in, it will be subject to taxes and penalties if you’re younger than retirement age.

That makes Roth IRAs your best first choice when you need to dip into retirement savings without dealing with extra taxes. Make sure you withdraw only what you put in, or you will end up with a tax and penalty situation.

Next Steps

As your finances stabilize, you’ll want to replenish emergency savings and nonretirement resources along with retirement accounts. That’s especially important when you’re dealing with an ongoing hardship situation.

In that case, you’ll want to rebuild accessible emergency savings first. Make sure this money goes into an FDIC-insured bank account as you cannot afford to lose any of it. Keep this cash at least one step away from your regular checking account so you’re not tempted to use it for nonemergencies.

After that, prioritize contributing to a Roth IRA. You’ll miss out on the immediate tax benefit, but you’ll be able to withdraw that money tax and penalty-free when you need it – with the added bonus that all earnings will be tax-free once you reach retirement age.

Next, contribute what you can to your employer-based retirement plan, especially if they offer matching contributions. Finally, fund non-retirement savings and investment accounts. They don’t offer tax advantages but you won’t face additional taxes or penalties when you use that money.

Michele Cagan, CPA, is a SmartAsset financial planning columnist and answers reader questions on personal finance and tax topics. Got a question you’d like answered? Email [email protected] and your question may be answered in a future column.

Please note that Michele is not a participant in the SmartAdvisor Match platform.

Investing and Retirement Planning Tips

• Consider working with a financial advisor for guidance on how to handle retirement accounts. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.

• As you plan for income in retirement, keep an eye on Social Security. Use SmartAsset’s Social Security calculator to get an idea of what your benefits could look like in retirement.

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