Avoid Nest Egg Penalties
Once you've accumulated a sizable retirement nest egg, you can congratulate yourself. You put aside excessive spending in favor of prudent saving and investing for years at this point in your journey. Retirement planning, on the other hand, does not end with retirement savings.
Additionally, you'll need to budget for retirement so that you and possibly a spouse can live comfortably in retirement. As you begin, you must avoid premature withdrawals of your funds. During the accumulation stage, you must exercise extreme caution with your retirement assets. Then, determine how long your money will last in retirement, invest appropriately, and schedule appropriate account withdrawals.
Avoid Early Withdrawal of Retirement Funds
Many people's retirement savings are concentrated in their 401(k) or IRA retirement accounts, if not entirely. Early withdrawals or borrowing from a retirement account divert funds away from their intended use and eliminate the opportunity for tax-deferred growth. When additional financial needs arise, the desire to access the funds for non-retirement purposes is frequently expressed. When Congress established the tax-favored status of the accounts, such uses were not contemplated. Early withdrawals imply that you must either postpone retirement or accept a lower standard of living upon retirement. Both of these are disadvantageous.
Early Withdrawals are typically defined as distributions made before the age of 59½ and are taxed as ordinary income. When money is withdrawn directly from a tax-sheltered retirement account before the rules allow, four negative consequences occur:
You will prepay taxes that will be due to the government. The IRS's 20% withholding rule applies when a participant takes direct possession of funds grown from pretax contributions to a retirement account. The trustee of the retirement plan account transmits this amount to the IRS to prepay a portion of the income taxes due on the withdrawn funds. Example: If John Stevenson withdraws $20,000, he will receive a check for only $16,000 ($20,000 – ($20,000 x 0.20)).
The IRS assesses a 10% early withdrawal penalty on such withdrawals. Additionally, Mr. Stevenson must pay a $2,000 ($20,000 x 0.10) penalty tax for withdrawing $20,000 from his account.
You will pay income tax on the withdrawn funds. Withdrawals made early are taxed at the individual's marginal tax rate. Taxes and the penalty have a sizable impact. Mr. Stevenson, a 35-year-old with $50,000 in a tax-sheltered retirement account at his place of employment, withdrew $20,000 from the account to take his family on vacation. Mr. Stevenson is subject to a combined federal and state income tax rate of 30%. His $20,000 withdrawal is considered income and must be included in his taxable income. Mr. Stevenson will pay a total of $8,000 (of which $4,000 was paid in advance). This amount includes $6,000 in income tax ($20,000 x 0.30) and $2,000 for the 10% early withdrawal penalty ($20,000 x 0.10). These costs add up to a relatively expensive vacation for the Stevenson family.
The investment does not increase in value. Withdrawing money implies that the funds are no longer growing in tandem with the invested portfolio. Compounding time lost significantly reduces one's retirement nest egg. Mr. Stevenson permanently forfeited an estimated future value of approximately $500,000. (30 years, assuming 8 percent return).
There are Some Penalty-Free Withdrawals Available
Despite the costs associated with early withdrawals, in certain circumstances, a withdrawal may be necessary. Fortunately, the IRS does not impose penalties on early withdrawals in four circumstances:
Medical, college, and home-buying expenses. You may make penalty-free withdrawals from an IRA account (but not from an employer-sponsored plan) if your medical expenses exceed 10% of your adjusted gross income, you pay medical insurance premiums after being on unemployment for at least 12 weeks, you are disabled, you pay for qualified higher-education expenses, or the distribution is used for qualifying first-time homebuyer expenses.
Account Loans. You may borrow up to half of your accumulated assets in an employer-sponsored account, not to exceed 50 percent of your vested account balance, or $50,000, whichever is less. Here, the borrower pays the loan's interest with after-tax funds, which are then credited back to the borrower's account. If the employee changes employers, they must repay the unpaid balance of the loan within 30 days. Otherwise, the loan will be reclassified as a withdrawal, subjecting you to additional taxes and penalties. Account loans are only advantageous in exceptional circumstances. The borrower should immediately make repayment arrangements after taking out the loan.
Hardship Withdrawal. According to the IRS, a hardship withdrawal is a distribution from a 401(k)-plan made in response to an employee's immediate and severe financial need, and the amount must be sufficient to meet the financial need. Examples include unreimbursed medical expenses, payments to avoid eviction, funeral expenses, college tuition, and home purchase. The vast majority of 401(k) plans do not allow for hardship distributions. Plans that permit hardship withdrawals must notify the IRS, which may or may not treat the withdrawal as tax-free.
Early Retirement. You may avoid paying a penalty if you retire early (but no earlier than 59.5 years) or become totally or permanently disabled and agree to receive annual distributions using an IRS-approved method for a time period of no less than five years.
Will Your Money Last in Retirement
As you approach retirement, you'll want to consider the following: "How long will my retirement nest egg last?" The answer to this question will depend on three factors: (1) the amount of money you have accumulated, (2) the real (after inflation) rate of return on the funds, and (3) the amount of money to be withdrawn from the account each year because the faster you withdraw money from the account, the less likely the assets in your portfolio will last throughout your entire retirement. One of the most common mistakes made by new retirees is withdrawing money too quickly.