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Tax Tips for Withdrawing Retirement Funds Early

2012 July 20
by Guest

**This is a guest post from my (Charlie) mother-in-law, who has always given me great tips to lower my tax bill. Enjoy!**

As a certified public accountant, one of my most frequently asked questions during the last year was “What are the tax consequences for taking money out of my retirement fund to pay consumer debt down?”

Consumer and credit card debt has become overwhelming and sometimes retirement funds appear to be the only viable option.  One of the worst mistakes people make is pulling out the funds and not checking with their tax preparer until it is time to do the tax return.  If you are not prepared, you could be facing another debt with the added tax liability of early withdrawal of funds.  Usually, the company does not withhold enough to cover the tax liability. 

I always recommend my clients to look at other options first and only use retirement funds as a last resort.  If retirement funds are used, consult your tax preparer first and find out the tax and early withdrawal penalty applicable to you.  Taxes and penalties range from 20 to 50 percent of the gross amount depending on the state you live in and your tax bracket.  Then under most circumstances, I have the client withhold the applicable federal and state taxes upfront; this makes it easier on the client when doing the tax return.  Getting the right information upfront before you do the withdrawal, will help you make a better decision for your circumstances.

FAQ’s

1) How much should person initial withdraw from their retirement accounts?

I would advise my clients to never take more out of a retirement account than absolutely necessary.

2) What account do you recommend withdrawing from first? 401k, Post-tax IRA, Regular IRA, Roth IRA, or Roth 401k?

If the money is being used for education expense, taking the money out of an IRA will avoid the 10% federal and state penalty.  Otherwise, the ROTH  will have the least tax consequences because it is after tax contributions. 

3) Are there any tips to help reduce the tax burden from making a retirement account withdrawal early?

As far as tips to reduce the tax burden, my best advice is to speak with your tax preparer, because every situation is different.  Withholding the estimated tax liability from the withdraw of funds makes it easier when you do your tax return.  Another thing to keep in mind is that some 401K’s allow you to borrow money – to be repaid back at a later date.  This could be the answer for some situations.   When you borrow from the 401k, there is no tax consequence at the current time. 

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