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If you’re under age 59½ and withdraw money from a traditional IRA, the distribution will generally be taxable, and it may also be subject to a 10% early withdrawal penalty. However, understanding how withholding works, and when exceptions apply, can help you avoid surprises.
Income Taxes vs. Withholding
It’s important to distinguish between:
- Income tax owed
- Tax withholding at the time of distribution and
- The 10% early withdrawal penalty
These are related but not the same.
Income Taxes
Traditional IRA distributions are generally taxed as ordinary income at your federal (and possibly state) income tax rates.
Example: Mike, a 42-year-old Michigan resident, withdraws $5,000 from his traditional IRA to fund a trip to Europe. The full $5,000 will generally be included in his taxable income for the year.
Federal Withholding Rules (IRA vs 401k)
Withholding depends on the type of retirement account and the type of distribution. Withholding is key because it reduces the actual amount of cash you receive when distributions are made (i.e., key for planning).
IRA Distributions
For nonperiodic IRA distributions (like a one-time withdrawal):
- The default federal withholding rate is 10%
- You may elect any rate between 0% and 100%
- There is no mandatory 20% withholding rule for IRAs
Example: In Mike’s case above, federal withholding is $500 or ($5,000 x 10%). Michigan state withholding would be $213 ($5,000 x 4.25%). This results in a net distribution of $4,287.
401(k) and Employer Plan Distributions
Employer-sponsored plans (such as 401(k)s and 403(b)s) follow different rules. If a distribution is an eligible rollover distribution paid directly to the participant:
- Mandatory 20% federal withholding applies
- You cannot elect less than 20%
- You may elect more
Planning Notes: These 401(k) or 403(b) withholding rules do not apply to IRAs. However, Certain employer plan distributions, such as Required Minimum Distributions (RMDs) or hardship withdrawals, follow voluntary withholding rules instead.
The 10% Early Withdrawal Penalty
In addition to the withholding above, Mike may also be subject to a 10% early withdrawal penalty, unless an exception applies. The exceptions are discussed below. An important not here is that the penalty is calculated on the tax return which usually requires additional budgeting considerations.
Example: Using the same facts as the prior example, Mike will also be subject to a $500 penalty ($5,000 x 10%). This would reduce his net cash to $3,787 ($5,000-$500-$213-$500).
While the primary 10% penalty for early retirement account withdrawals (before age 59 ½ ) is federal, some states impose their own additional penalties on early distributions from 401(k)s and IRAs. For example, California, imposes a 2.5% penalty which results in a total penalty of 12.5% (10% – 2.5%).
Exceptions to 10% Penalty
Below are exceptions listed in IRS Publication 590-B regarding the 10% penalty (“additional tax”) on early distributions from tax deferred accounts, including the amounts and timing requirements.
Key Takeaways
- IRA default withholding is 10%, not 20%.
- 401(k) lump-sum distributions may require mandatory 20% withholding.
- Withholding is not the same as tax owed.
- The 10% penalty is separate from income tax.
While it’s usually best to preserve retirement funds for their intended purpose, understanding these rules can help reduce costly surprises.
Conclusion
While it’s best to avoid dipping into retirement funds early, things happen, but understanding the rules will assist in budgeting and reduce anxiety.
Disclaimer: The information provided herein is intended solely for informational purposes and no person(s) or other third-party may rely upon it as financial, tax, or legal advice or use it for any other purposes. As a result, Royal Financial, and any affiliates, assume no responsibility whatsoever to readers, or any other persons for that matter, as a result of the information contained herein.