Retirement is a bitch, and saving for it is even harder.
I've made a lot of mistakes along the way, and I expect I'll be working well into my late 60s even though I did make a few good decisions and have a solid pension to depend on beyond social security. That said, mistakes are costly, especially when they come with tax penalties.
Early Withdrawals
One of the most problematic issues with a retirement account involves taking the money out too soon. Aside from the fact that it reduces your funds actually available for retirement, the government penalizes you with taxes for doing so if you do it wrong. The idea is to keep the money in the retirement account had have it for when you are older. Unfortunately, life and shit happen, so there are needs. Anticipating some valid reasons, the government (at least in the U.S.) also provides a few exemptions to penalties. Those include first-time homebuyers, higher education costs, paying the government for taxed owed (gotta like that one!), and financial distress/hardship (i.e. almost in bankruptcy). If your early pull doesn't fall into one of these buckets, then the government hits you income tax charges on the value of the money if pre-tax and on any gains if post-tax.
Pre-tax, post-tax, wth is that? For background, any money you earn and save before having to give up withholding for income tax is pre-tax money. Any money you save after withholding is post-tax. So, a traditional 401K or traditional IRA (individual retirement account) is pre-tax. It gets taxed when the money is actually withdrawn for your own use. And by 73.5 years of age, you have to pull it out per government rules. This mechanism provides consumers a valid tax shelter while they are earning money and, when they do use the savings, it's usually charged at a lower tax rate because they are earning less in old age.
Post-tax monies end up in mostly Roth IRAs or Roth 401ks. This is money that is after withholding is applied, and net of any other taxes. However, you will still owe taxes on any gains, like interest or investment bonuses. Putting it in a retirement account allows you to keep growing without taxes applying each year, and you only pay taxes on the gains at the time you pull it out, after the right age.
What Happens if I Don't Have an Exemption?
Essentially, the retirement account manager sends you and the IRS a report of how much you pulled out. Depending on the account type and if any exemption applies, you either owe income tax on it and a penalty if you're younger than 59.5 years of age. Woah. How much is that penalty? Depending on your tax bracket, it could be as much as 30 percent of the total pulled out. Woah x2!
The Education Exemption
So this is where I made my mistake. I pulled out funds to may for my kid's college so she would have a huge student loan. However, I pulled it out of the wrong account. While the Roth IRA has a higher education exemption, the 401K does not. Double-zap on the third rail! Now I have a very painful penalty to pay for 2024 on my income taxes. Ugh. I still would have done it to help her, but I probably would have planned better and different knowing the details.
Easy to Use References
Fortunately for those who do research before doing dumb things like me, there is now a very handy chart for retirement account exemptions. And it's provided by the IRS, believe it or not! Here's a snippet from the main list (which is a lot bigger):
This is going to be come very handy as IRAs and 401Ks eventually start to dabble into crypto assets as well (and you thought this article had nothing to do with crypto...mwhahaha!). While you won't probably be able to buy Bitcoin with your Roth in 2025, there's a very good chance crypto ETFs will become accessible to retirement account investing over the next two years. And that could produce some serious attractions for early withdrawals. Make sure to do your homework if so.
