What happens if you take out an early withdrawal against your workplace retirement?

Unexpected hardships or emergencies may require us to think of alternative sources of getting money quickly. Sometimes this may take the form of withdrawing early from your workplace retirement plan. In some cases, withdrawing from a retirement plan may not have a major impact; in others, the consequences may be significant from a financial perspective. Which consequences you’ll face depends on what type of plan you have, when you withdraw and why you are using your retirement plan funds. There are several potential outcomes when you withdraw from your workplace retirement plan early. Here’s what you need to know as well as some alternatives that might be a better fit for your finances.

Withdrawing from your account

When you’re in need of financing, it may seem like withdrawing from your workplace retirement plan is a viable option. After all, your retirement savings account may seem like a prime source of money when you need it in a pinch. It’s not ideal to pull from these funds early, however. Nor is it as straightforward as selling equities in your portfolio.

To withdraw from some workplace retirement plans, you must first qualify for a hardship withdrawal. Hardship withdrawals are available to people with specific financial needs as defined by law.1 These include: 

  • College tuition payment for yourself, your spouse, dependents or non-dependent children
  • Payments to avoid foreclosure or eviction from your home (excluding mortgage payments)
  • Funeral and burial expenses for parents, spouses, children or dependents
  • Medical bills not reimbursed by your insurer for you, your spouse or dependents
  • Down payment or, in some cases, repairs to your principal residence

If you decide you take a hardship withdrawal, you may not be able to contribute to your workplace retirement plan for six months or more. The IRS also prohibits you from withdrawing more than you need to cover the hardship plus local, state, and federal income taxes or penalties.

Some types of retirement plans (like 457s), do allow for “early” withdrawals. If you leave your job or retire, you may be able to withdraw funds without penalty — even if you’re under retirement age. If, however, you are still employed with your employer, you must qualify for an “unforeseeable emergency” to take a withdrawal without paying a penalty to the IRS. Unforeseeable emergencies include:

  • Illness or accident expenses for you, your beneficiary, or you or your beneficiary’s spouse or dependents
  • Property loss caused by casualty (for example, damage from a natural disaster not covered by you or your beneficiary’s homeowner insurance)
  • Funeral expenses for your spouse or dependents
  • Other similar extraordinary and unforeseeable circumstances resulting from events beyond you or your beneficiary’s control (for example, imminent foreclosure or eviction from a primary residence, or to pay for medical expenses or prescription drug medication).2
     

The tax implications of early withdrawal

If your retirement account requires you to be age-eligible, withdrawing from your account before that age means facing significant tax penalties. After all, you’re growing your retirement nest egg tax-deferred with a workplace retirement plan. This means the IRS is going to want you to pay your tax bill, in full, for the money you withdraw early. Worse yet, the penalties you might have to pay for early withdrawal could be higher than what you’d pay in tax during retirement.

Your early withdrawal gets taxed as regular income, which will range between 10% and 37% depending on your total tax-eligible income. There’s an additional 10% penalty on early withdrawals.3 Your tax bracket is likely to decrease in retirement, which means pulling from your workplace retirement plan early could result in paying more in tax today than you would if you left the money untouched. That’s even before factoring in the IRS penalty.

The retirement implications of early withdrawal

Account withdrawals don’t just impact your tax bill, they also hamstring your retirement savings goals. Removing money from your account doesn’t just reduce its current balance, it also impairs your ability to grow investments through compounding interest.

A hardship withdrawal may prevent you from contributing to your early withdrawal from your workplace retirement plan for at least six months, depending on the plan’s policies. This essentially bars you from replacing the money quickly. You will also lose out on any employer matching contributions for half a year, which may significantly reduce your earning potential.

The long-term impact of early withdrawals can follow you all the way through retirement. Withdrawing from your account (either from hardship, unforeseeable emergency or otherwise) means losing compounding interest. When your investments pay dividends, those funds get reinvested into your account. That money then grows over time, thus increasing your retirement nest egg. When you withdraw money from the account, you’re essentially diminishing the impact of compounding interest. This can spill over into the total amount of money in your account over the long term, thus equating in less retirement income.

Alternatives to early withdrawals

Your workplace retirement plan should be among the last places you look for money in a pinch. There are several options available that you may not have considered.

A Roth IRA provides you with more withdrawal flexibility. You can withdraw against your principal tax-free; withdrawals of earnings or dividends come with a 10% penalty. There are some instances in which you can avoid the penalty, such as buying your first home, paying for certain higher education-related expenses, paying back taxes, disability, or unreimbursed medical expenses.

If you own a home, you may also want to consider borrowing against its value. A home equity line of credit (HELOC) can help you access cash without the same consequences as an early withdrawal from your workplace retirement plan. With a HELOC, you can establish a revolving line of credit that you can pull from several times throughout the duration of its term. You can choose to borrow the full amount or just some of the total offered. You can also choose a home equity loan if you need a lump-sum payment once, rather than a revolving loan.

Making smart short- and long-term financial plans

Accessing cash when you need it can be a stressful challenge. There are a variety of options available to many people that are, in most cases, a better financial move than taking an early withdrawal from a retirement account. Withdrawing from workplace retirement plans early can cost you significantly in terms of taxes, penalties, and unrealized gains in the future. You may even find that you’ve set yourself back over the long-term and have less money in retirement than you would if you sought other financing options.

With a variety of financing options available to you, it can be difficult to make the right move. That’s why it’s essential to work with financial professionals to help you determine your options, calculate the costs and benefits of each, and to put you on a path that helps you stay liquid today while planning for the future.

 

Related Items

  1. IRS. (2022). Hardships, Early Withdrawals and Loans | Internal Revenue Service. https://www.irs.gov/retirement-plans/hardships-early-withdrawals-and-loans
  2. IRS government https://www.irs.gov/retirement-plans/employee-plans-news-december-17-2010-unforeseeable-emergency-distributions-from-457b-plans 
  3. IRS. Topic No. 558 Additional Tax on Early Distributions From Retirement Plans Other Than IRAs | Internal Revenue Service. Retrieved 2022, from https://www.irs.gov/taxtopics/tc558

This information is provided by Voya for your education only. Neither Voya nor its representatives offer tax or legal advice. Please consult your tax or legal advisor before making a tax-related investment/insurance decision.

Products and services offered through the Voya® family of companies.

 

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