Withdrawing from Retirement to Pay Taxes is the Last Resort
People may withdraw from their retirement accounts early for a variety of reasons, including unexpected medical expenses, job loss, or other financial emergencies. It is important to acknowledge the difficult circumstances that may lead someone to consider early withdrawal and to show empathy for their situation. Early withdrawal from retirement accounts can have significant tax consequences in the United States, particularly for individuals under 59 and 1/2. While there are certain circumstances where early withdrawal is allowed without penalty, these exceptions are limited and can be difficult to qualify for.
It is important to understand the potential tax consequences of early withdrawal. In addition to ordinary income taxes on the withdrawn amount, there is generally a 10% penalty for early withdrawal. This penalty is intended to discourage individuals from using their retirement savings before they reach retirement age. There are some exceptions to the penalty, including withdrawals for certain medical expenses, higher education expenses, and first-time home purchases. However, even if an individual qualifies for an exception, they will still owe ordinary income taxes on the withdrawn amount.
It is uncommon for individuals to avoid the early withdrawal penalty entirely. While some exceptions exist, they are limited and can be difficult to qualify for. According to a recent study by the Investment Company Institute, only 4.4% of traditional IRA withdrawals in 2017 were penalty-free. It is important to carefully consider the tax consequences before making an early withdrawal from a retirement account.
Furthermore, withdrawing from an IRA to pay income taxes can create even more tax liability. This is because the withdrawal itself will be subject to ordinary income tax, and the additional tax liability can be substantial. As a result, it is generally not recommended to use retirement savings to pay income taxes.
To illustrate the potential tax consequences of early retirement account withdrawals, let's consider an example. Suppose a taxpayer under the age of 59 and 1/2 withdraws $20,000 from their traditional IRA. Assuming a 10% penalty and a 22% marginal tax rate, the taxpayer would owe $5,600 in taxes and penalties, leaving them with only $14,400 of the original $20,000.
If the taxpayer withdraws from the account again to pay the taxes, then they will have an additional 10% penalty and an additional 22% tax on the extra withdrawal.
Additional taxes can be catastrophic because taxpayers are faced with the choice of not paying their bills or staring down the IRS.