Most of us know there’s a financial penalty for withdrawing money from various retirement accounts before reaching a certain age. Understanding exactly how hard you’ll be hit and how much longer you need to wait can potentially save you thousands of dollars. At the very least, we hope to give you enough information to make you think twice!
Tax-advantaged accounts are the primary savings tools that require you to abide by a withdrawal timeline to avoid penalties, but we’ll also touch on Social Security and stock market investments.
Early Withdrawals From an IRA
Early withdrawals from an Individual Retirement Account (IRA) before age 59½ are subject to being included in gross income plus a 10% tax penalty. With a bump to your gross income, you could find yourself in a new tax bracket. There are exceptions to the 10% penalty, such as using IRA funds to pay your medical insurance premium after a job loss.
Now there are differences when it comes to a Roth IRA and a Traditional IRA. You should always expect to pay taxes upon a Traditional IRA withdrawal as the money has not been taxed. And plan on paying the 10% penalty if you have yet to reach 59 ½. But in the case of a Roth IRA, you’re contributing money that you’ve already paid income taxes on.
There is a five-year holding requirement associated with Roth IRA withdrawals. As long as you meet the five-year holding rule, meaning 5 tax years have passed from your first deposits or from the time of the Roth conversion, you can withdraw funds you contributed without penalty or additional taxation. Remember, this does not apply to the gains or interest the account has accrued and you will be hit with the 10% penalty if you do not abide by the five-year rule or withdraw more than you contributed (dipping into the growth).
401(k) Early Withdrawal
An early withdrawal from a 401(k) comes with the same penalty as pulling money out of your IRA. While you always have the option to withdraw, the distribution will be added to your taxable income come tax time.
Not only will you owe income taxes, but you’ll be assessed a 10% penalty if you’re under the
age of 59½. Again there are scenarios where individuals are given a break for facing certain hardships such as becoming disabled and losing the ability to work.
Social Security
Social Security does not come with penalties, but you do have some control over the size of your monthly payment. To maximize your benefit, you must know your full retirement age, per the Social Security Administration.
You are allowed to begin collecting Social Security benefits at the age of 62. Before making the decision, make sure you have a clear understanding of how a deferral can positively impact your monthly payment.
The government rewards retirees for pushing back their first collection date in exchange for a larger monthly payment. While a few months won’t make a noticeable difference, if you have the option to wait, a year or more will add a bit of extra padding to your pocket.
The Social Security Administration will increase your monthly payout by a set percentage each month you defer, up to the age of 70. The SSA has stated those born after 1943 will receive an 8% annual credit for each year they push back cashing in their benefit beyond their full retirement age.
However, taking your social security before your full retirement age will result in a permanent reduction in your monthly benefit. For those born in 1960 and later, taking social security at age 62 will cost you a 30% reduction compared to waiting until your full retirement age.
Investments in the Stock Market
We’ve covered the most common retirement income streams, but what about the cash you’ve put into the securities market, earmarked for retirement? When selling equities like stocks or real estate, you’ll likely face capital gains taxes.
For simplicity, if you purchased stocks for $10,000 and sold them for $15,000, your capital gain is $5,000. You will owe capital gains taxes on the $5,000. The tax rate is determined by how long you owned the stocks. If you owned the stocks for less than a year, you’ll owe short-term capital gains taxes, which is often your standard income tax rate.
If you held the stocks for more than a year, you’ll owe long-term capital gains. The benefit to holding on to stocks longer than a year is that long-term capital gains taxes are less than short-term rates. Managing capital gains taxes is important, leading many to partner with a knowledgeable tax advisor. Where you live, when you sell, or who/when you’re passing on assets to all come into play when making tax-related decisions.
Don’t Let Early Withdrawal or Taxes Throw Your Retirement Off Course
Whether you've realized it or not, this article is all about tax planning. IRAs and 401(k)’s are tax-advantaged accounts, and the associated penalties are assessed at tax time. Social Security is funded by taxpayers. Capital gains taxes are again, enforced through the tax code.
There are smart ways to navigate taxation to help keep as much of your hard-earned money for you, rather than unnecessarily handing over extra to Uncle Sam. While tax laws can be complex, we all have the same ability to utilize them in a manner that best suits our financial situations.
Tax planning is a large component of our wealth management services. By partnering with Integrated Wealth Management, every important financial transaction you conduct can be reviewed through the lens of a tax expert.
About Integrated Wealth Management
Integrated Wealth Management is owned by Burt Hutchinson, CPA, CFP®. We’re a CPA-led organization, meaning we’re here to handle your complex tax scenarios and provide cost-saving insight related to your financial plan.
We’re here to guide you through the 3 stages of retirement:
Uncertainty Stage: When you are within 10 years of retirement and have questions about how to make it work
Stability Stage: When you have reached the financial milestone to retire comfortably and confidently
Reflection Stage: When you are looking to leave a legacy
We are also here to provide experienced, empathetic support during times of loss, such as the death of a life partner. You need confidence and a sense of security to enjoy retirement. As fiduciaries with a fee-only structure, we never receive commissions. Free of ulterior motives, you can be sure we’re focused on your goals.
Continued Readings:
Sources:
Social Security Administration. “Securing today and tomorrow.” Retirement Benefits. 27, April, 2023. https://www.ssa.gov/pubs/EN-05-10035.pdf
Disclosure Statement:
This presentation is not an offer or a solicitation to buy or sell securities. The information contained in this presentation has been compiled from third-party sources and is believed to be reliable; however, its accuracy is not guaranteed and should not be relied upon in any way whatsoever. This presentation may not be construed as investment, tax, or legal advice and does not give investment recommendations. Any opinion included in this report constitutes our judgment as of the date of this report and is subject to change without notice.
Additional information, including management fees and expenses, is provided on our Form ADV Part 2 available upon request or at the SEC’s Investment Adviser Public Disclosure website, Past performance is not a guarantee of future results.