Retirement savings accounts are a growing source of emergency cash for Americans hurt by the weakeconomy.
Hardship withdrawals from 401(k) plans have increased since the Great Recession hit, according to Fidelity Investments, and with unemployment hovering around 10 percent more people are no doubt eyeing their nest egg to pay the bills.
But such moves come with serious tax consequences. To prevent a bad situation from becoming even worse, here are some ways to minimize taxes on an early withdrawal from a retirement account.
Tap a Roth IRA
Due to the tax-deferral provided by 401(k) s and traditional IRAs, pulling money from these accounts prior to age 59-1/2 usually triggers state and federal income tax plus a 10 percent early withdrawal penalty.
Taking money from a Roth IRA instead of a traditional IRA is one way to skirt taxes. Because you pay tax upfront on your contributions, Roth IRAs assess no tax and penalty on withdrawals of your original investment as long as you’ve held the account for five years.
Pay It Back Quickly
If you’ve already taken a distribution from an IRA, you have 60 days to replace the money without triggering any tax or penalty.
Search for Loopholes
Certain exceptions allow you to skirt the 10 percent penalty. These include qualified college expenses, medical insurance premiums if unemployed, or payment resulting from a disability or death.
One loophole for cash-strapped investors nearing retirement age is to take equal payments from a traditional IRA. Also called a rule 72(t) distribution, this option enables you to take equal annual payments from your retirement account for either five years or until age 59-1/2 (whichever is longer). Distributions are penalty free but still subject to income tax.
“I started tapping my IRAs when I was 54 by using the "substantially equal payments" method,’’ says Joe Bruno, an author in Sarasota, Florida. “The only problem I had was coming up with the right figure to withdraw every year.”(Try this calculator.)
Analyze Your Account Choices
If you must take an early withdrawal, which one you choose will affect your tax bill.
Here’s how the three most popular retirement accounts stack up.
Do Some Tax Planning
To keep the check you write to Uncle Sam manageable, tax experts suggest doing the following:
In these situations, itemizing deductions becomes more valuable. Medical expenses, for example, can be written off if they account for 7.5 percent or more of your income – that’s an easier hurdle to cross if your pay has fallen.
Estill’s advice: “hammer the itemized deductions.”