Article Highlights: Tapping Retirement Funds Taxability Traditional IRAs Roth IRAs Qualified Plans Withdrawal Option Early Retirement Separation from Service Disability Special Financial Needs Unreimbursed Medical Expenses Qualified Reservist Distributions Medical Insurance Higher Education First-Time Homebuyer Exceptions Special Situations If you are suddenly in need of a substantial amount of cash, probably the last thing you should do is tap your retirement funds. They are the key to a financially comfortable retirement. The younger you are, the less likely you are to think about saving for retirement, but you certainly don’t want to end up living off of only Social Security. However, there are times when there might not be any other alternative than dipping into your 401(k), IRA or other retirement plan. In that case, you have to be concerned not only with any tax liability, but also early withdrawal penalties if the funds are withdrawn before reaching age 59 1/2 Plus, some distributions may only be partially taxable and some not taxable at all, while others are fully taxable. Like everything in the U.S. tax code, the rules relating to pension or other retirement plan distributions are complicated and governed by a variety of provisions. This article describes these various rules so you can see how they would apply to a withdrawal you might be contemplating. TaxabilityTaxability depends upon the type of retirement vehicle your retirement funds are invested in and sometimes depends on whether the contribution was made with post-tax or pre-tax dollars. Post-tax means the contribution was made with funds that were already taxed and are not included in income when later withdrawn. Pre-tax means the contribution was made with income that was not taxed, and as you might expect, are taxable when later withdrawn. Here is how that plays out in different types of retirement vehicles: Traditional IRA – Contributions to traditional IRAs are made with post-tax dollars, but a deduction for the contribution is allowed on the individual’s tax return. Thus, distributions are treated like pre-tax contributions and are taxable, as are the earnings and gains made on the contributions. There is an exception because the deductibility of traditional IRA contributions is phased out for certain higher-income taxpayers, in which case the portion of the contribution that is not deductible is tax-free when distributed. In this case, each distribution will include a prorated portion of the non-deductible contributions and that prorated amount will not be taxed. There is also a penalty of 10% of the taxable distributions from traditional IRAs if the distribution occurs before the account owner is age 59 1/2 and none of the exceptions explained below apply. Some states also assess an early withdrawal penalty. The primary benefit of a traditional IRA is the deductibility of the contribution. Roth IRA - Contributions to a Roth IRA are made with post-tax dollars. However, unlike a traditional IRA, the contributions are not deductible because the distributions from a Roth IRA that meet a five-year aging requirement and are distributed after age 59 1/2 are tax-free. These IRAs were designed so that their investment earnings would be tax-free when the individual retires. However, the original contributions, excluding the earnings and traditional IRA-to-Roth conversions that have not met the five-year aging rule, can be withdrawn at any time without any tax or penalty consequences. The primary benefit of a Roth IRA is the tax-free investment earnings accumulation. Qualified Plans – Generally, contributions to employer-sponsored qualified plans, including 401(k)s, simplified employee pension plans (SEPs), SIMPLE plans, tax sheltered annuities and others are made with pre-tax dollars and distributions are taxable and subject to the 10% early withdrawal penalty if withdrawn before age 59 1/2. However, some plans may offer a Roth option wherein the contributions are made with post-tax dollars; in these arrangements, the tax treatment is the same as a Roth IRA. Retirement Withdrawal OptionsThe following retirement withdrawal options are taxable as described above, and penalty free. Distribution not meeting one of the following options will be subject to the 10% early withdrawal penalty in addition to any tax liability. After reaching age 59 1/2 - Tax law considers distributions after reaching age 59 1/2 as made during normal retirement and withdrawals from all plans are penalty-free. Early Retirement – This form of retirement essentially allows a taxpayer to retire early and take penalty-free withdrawals before reaching age 59 1/2 For qualified plans, this exception applies only for distributions that begin after the taxpayer separates from service. To qualify for early retirement and avoid the 10% early withdrawal penalty, the payments: Must be part of a series of substantially equal payments over the taxpayer’s life, or the joint life expectancies of the taxpayer and the taxpayer’s beneficiary, and Payments under this form of retirement must continue for at least 5 years, or until the taxpayer reaches age 59½, whichever is the longer period. This 5-year rule does not apply if a change from an approved distribution method is made because of the death or disability of the IRA owner. Example: Dan began taking eligible payments at age 56 on December 1, 2017. He may not take a different distribution or alter the amount of the payment until December 1, 2022, even though his fifth payment was taken on Dec. 1, 2021. Example: Sue began taking substantially equal periodic payments on December 1, 2011. She turns 59 1/2 on July 1, 2018. She may not take a different distribution or alter the amount of the payment until July 1, 2018.