Retirement plans are designed to help you save money for retirement. As a result, there are certain rules and restrictions on when you can withdraw the money. You may be able to cash out your retirement plan prior to your scheduled retirement date. However, if you do, you'll probably pay a penalty on the money withdrawn as well as income tax on that amount.
Traditional Qualified Plans
Traditional qualified plans include traditional IRAs and 401k plans. These plans may be cashed in prior to you reaching age 59 1/2, but you will owe income tax and a penalty on the amount you cash in. The amount of the penalty is 10 percent of the amount withdrawn. The tax due is ordinary income tax. You must pay the penalty and the tax in the year in which you receive the money.
When you make contributions to a Roth 401k plan or Roth IRA, the contributions are after-tax funds. This means you don't pay tax on the amount of money you withdraw from contributions to your plan. However, cashing in a Roth account prior to age 59 1/2 requires you not only pay a 10 percent penalty, but you also pay income tax on the investment gains in the account.
Non-qualified plans are plans that do not meet the requirements set forth by the IRS to qualify for all the tax benefits of qualified plans. An example of this would be an annuity. A non-qualified plan does have some tax benefits, though. For example, annuities are not taxed on the money growing in the policy. When you cash in your non-qualified plan early, you only pay tax on the investment gain. This is because non-qualified plans only accept non-deductible contributions. However, you'll still pay a 10 percent penalty on those gains along with ordinary income tax.
Instead of cashing in your retirement plan early, you might consider early distributions from the account under IRS rule 72(t) or 72(q) (for annuities). The IRS allows early withdrawals from your retirement plan as long as those withdrawals are equal and substantial. The withdrawals must last for at least five years or until you reach age 59 1/2, whichever comes later. You are still assessed income tax on your distributions, but you avoid the 10 percent penalty.
- "Practicing Financial Planning for Professionals (Practitioners' Edition), 10th Edition"; Sid Mittra, Anandi P. Sahu, Robert A Crane; 2007
- "Ernst & Young's Personal Financial Planning Guide, 5th Edition"; Martin Nissenbaum, Barbara J. Raasch, Charles L. Ratner; 2004
- IRS: Publication 590
- IRS: Publication 575
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