Personal Finance

New parents can take penalty-free early withdrawals from retirement savings, but it will increase your taxable income

Key Points
  • The Secure Act, which was passed by Congress last month, adds one more reason individuals can draw from their personal retirement savings before age 59½ without having to pay a 10% penalty.
  • Now, new parents join the list of those eligible for this exception. Other qualifying reasons include disability or medical expenses.
  • But taking those early withdrawals will still increase your taxable income. And long-term it could be a losing strategy.
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New parents will have one new source to tap for money — their retirement savings.

The Secure Act, which was passed by Congress in December, is ushering in some of the biggest changes to retirement savings since the Pension Protection Act of 2006.

But experts warn that tapping your retirement accounts, even if it is to care for a new child, may not be the best financial decision.

First, a look at what the change means.

The new rule will let parents who have a new child take up to $5,000 out of their retirement plan or individual retirement account without having to pay a 10% penalty. Typically, individuals who are under 59½ have to pay a fine when they take those early distributions, except for certain circumstances.

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The $5,000 limit would apply to each parent, including those who have adopted children. So technically, a couple could take out up to $10,000 from their retirement savings, as long as they both have separate accounts in their own names.

But parents would still have to pay taxes on that income.

That's just one reason Ed Slott, CPA and founder of Ed Slott and Co. in Rockville Centre, New York, said taking these kinds of withdrawals — even if you don't have to pay the 10% early distribution penalty — is problematic.

One big reason: It's an expensive strategy.

Aside from owing taxes on that money, it also takes a dent out of your retirement funds. That's often money that has taken you years to accumulate — and could take years to replace.

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Some people may not have enough time before retirement to make up for that loss. Consequently, early distribution strategies should only be used as a last resort, Slott said.

"Retirement funds are for retirement," he said. "If you use them well before retirement, what are you going to have in retirement?"

The risk is also that you could get into a cycle of borrowing. Slott remembers one couple who took out around $30,000 from their retirement savings to pay for their wedding. They had to pay the 10% penalty, because there is no exception for taking out money for that reason. They also had to add that income to their taxes.

Then, because they didn't have the money to pay the tax bill, they withdrew more money from their retirement savings to cover it.

"This went on for years until they basically went through most of their retirement savings," Slott said.

Not all exceptions are the same

Investors are also susceptible to other problems when it comes early retirement withdrawals.

The new birth or adoption exception applies to retirement plans and IRAs. Other reasons that qualify for both kinds of accounts include death, disability and medical expenses.

Some exceptions are only relevant to IRAs. including paying for higher education, buying a first home or purchasing health insurance if you are unemployed.

Retirement funds are for retirement. If you use them well before retirement, what are you going to have in retirement?
Ed Slott
founder of Ed Slott and Co.

Then, some exceptions apply only to retirement plans. Some qualifying reasons include reaching age 55, or age 50 for public safety employees, or divorce through a qualified domestic relations order.

The key is to make sure that the reason you're taking the money matches the account you're taking it from, Slott said.

For example, people who retire from a fire department at age 52 will have to pay a penalty if they take a withdrawal from their IRA instead of a qualifying retirement plan, Slott said.

There are no financial hardship exceptions

Another thing a lot of people tend to get wrong is thinking that they do not have to pay a 10% penalty because they run into financial difficulty, such as losing a job.

"There's no financial hardship exception," Slott said, though people do go to court to try to fight that all the time.

The one special case is if you happen to live in a federally declared disaster area, where you could take out a limited amount of retirement money without paying a penalty, he said.

Be careful with dates

For some withdrawals, such as medical expenses, it's important to make sure you take the money out in the same year as the expense.

Paying medical bills is one reason for exemption from a 10% early distribution penalty from both retirement plans and IRAs.

But if the medical expense was incurred in December and you take the withdrawal from your retirement funds to cover it in January, you will still have to pay the 10% fine because the calendar year has changed. "It's two different years," Slott said.

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