What to know before withdrawing from a retirement account

Taking money out of a retirement account can be costly in three ways. The withdrawal may be taxed, it may carry an additional penalty if taken early, and the money no longer compounds for the future. Each of these depends on the type of account, the age of the account holder and the rules that apply, so the cost of one withdrawal can differ sharply from another. Reviewing the rules first is usually easier than correcting a mistake afterward.

The cost is also not only the amount that leaves the account. Money withdrawn from an investment stops participating in future growth, so the value it would have reached over many years is lost along with the withdrawal itself. That lost growth can be a large cost and is easy to overlook when a withdrawal feels like a small, one-time step.

Taxes on withdrawals from traditional accounts

Withdrawals from tax-deferred accounts, such as traditional retirement accounts, are generally taxed as ordinary income in the year they are taken, because the contributions and growth had not been taxed before. A large withdrawal can push you into a higher tax bracket for that year, which is one reason the timing and size of withdrawals matter. Tax may be withheld when the money is paid out, but withholding does not always match the final tax owed, so estimating the total in advance is worthwhile.

Withdrawals can also affect other income-linked costs. Higher reported income in a year can increase how much of certain retirement benefits are taxed and can raise some Medicare premiums for people enrolled in that program. The effect of a withdrawal can therefore extend beyond the income tax on the withdrawal itself, and the details depend on each person's income and enrollments.

Early withdrawal penalties and their exceptions

Many retirement accounts charge an additional tax on withdrawals taken before a set age, commonly 59 and a half under US rules. The additional tax is generally 10 percent of the taxable amount, on top of ordinary income tax. Exceptions exist for certain situations, such as disability, some medical costs and other circumstances defined in the rules, and the exceptions differ by account type. An exception that applies to one account may not apply to another, so the details matter.

Withdrawals are not always optional. Many tax-deferred accounts require minimum annual withdrawals once the account holder reaches an age set by law, and the penalty for missing a required amount can be substantial. The age at which required withdrawals begin has been adjusted over time, so the rule that applies to a given person should be checked rather than assumed.

Roth withdrawals and what counts as qualified

Roth-style accounts follow different ordering rules. In many cases, contributions can be withdrawn without tax or penalty because they were already taxed, while earnings may be subject to tax and possibly a penalty unless the withdrawal is qualified. A qualified withdrawal typically requires the account to have been open for a set period and the holder to meet an age or other condition. Keep track of how much of each Roth-style account consists of contributions, since that record affects how withdrawals are treated.

Loans, rollovers and withholding

Some workplace plans allow loans, which are repaid into the account rather than taxed as withdrawals as long as the repayment terms are met. Missed repayments can turn the outstanding balance into a taxable distribution. If a job ends while a loan is still outstanding, some plans treat the unpaid balance as a distribution, which can make it taxable. In either case, a loan balance treated as a distribution can also trigger the additional 10 percent tax for someone under the early-withdrawal age, on top of ordinary income tax. That added cost is easy to overlook.

When leaving a job, a distribution paid directly to you from an employer plan generally has 20 percent withheld for federal income tax if it is an eligible rollover distribution. To roll over the full amount through an indirect rollover within the 60-day window, you must replace the withheld 20 percent from other money. A direct rollover between institutions avoids both the deadline and the withholding.

A checklist before any withdrawal

Before taking money out, it helps to answer a few questions:

• How old is the account holder, and does a penalty exception apply?
• What type of account is it, and will the withdrawal be taxed as ordinary income, tax-free or a mix of both?
• How much tax may be withheld at payout, and how much might be owed when the return is filed?
• Would a loan, a rollover or a smaller withdrawal meet the need without the same cost?
• What would the money have been worth if it had stayed invested?

Some people spread withdrawals across several tax years instead of taking one large sum, which can keep taxable income in lower brackets. Whether that approach works depends on other income, the timing of expenses and the rules of each account, so it is worth modeling before acting.

A short calculation covering tax, penalty and lost growth can show whether a withdrawal is the right move or whether a smaller amount would meet the need. For individual decisions, a qualified tax professional or licensed financial adviser can review the numbers against your full situation.