Retirement plans such as 401(k)s and IRAs are powerhouse savings accounts, giving you a tax break either when you contribute to the account or when you withdraw your money — plus taxes are deferred while the money grows.
But if you dip into your retirement savings early — which generally means anytime before you reach age 59 ½ — you may be required to pay tax on those distributions, plus a possible penalty of 10 percent or more of your withdrawal amount.
The biggest factor dictating the taxes you pay, besides your age when you take withdrawals, is whether you have a traditional or Roth account. That’s because you’ll typically be taxed on withdrawals from traditional accounts, whereas distributions from Roth IRAs and Roth 401(k)s are tax-free — unless you fail to abide by specific rules.
Understanding how you’ll be taxed on your retirement money is important, particularly if you have a mix of traditional and Roth retirement accounts. Below we dive into how the most common types of retirement accounts — traditional and Roth IRAs, and traditional and Roth 401(k)s — are taxed, both on early withdrawals as well as distributions once you’re in retirement.
Traditional IRAs: When you pay taxes on withdrawals
To understand how withdrawals from a traditional IRA will be taxed, you first need to consider your age when you tap this account. Withdrawals from a traditional IRA will be taxed differently if they’re made before you reach the age of 59 ½ vs. after.
Early withdrawals from a traditional IRA
If you’re considering taking money out of your IRA before age 59 ½, then beware: You will likely pay taxes on the amount of money you withdraw and you may owe a penalty as well. This will leave you with just a fraction of the money you withdrew.
What's left after taxes and penalties
Suppose you make an early withdrawal of $10,000 from your traditional IRA account:
Your federal income tax bill will likely range from $1,000 to $3,700, depending on your federal income tax bracket. You may also have to pay an early withdrawal penalty of 10 percent, or $1,000, on this withdrawal.
You may owe state income taxes and penalties, too (though there are 13 states that don’t tax retirement income).
That means you’ll probably pay a minimum of $2,000 in taxes on this $10,000 withdrawal, and that’s only if you’re in the lowest income tax bracket and if your state doesn’t also tax that income.
The IRS imposes a penalty on early withdrawals to discourage savers from dipping into their retirement accounts early. That said, not all early withdrawals are subject to the 10 percent penalty, and the IRS allows some early distributions to be made penalty-free, including for certain types of hardships, to pay for qualified higher education expenses and to buy a first home.
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