What’s one big obstacle that discourages younger people from tapping into their 401(k) or 403(b) accounts before retirement? You guessed it: early distribution penalty. The IRS imposes 10% penalty if you take money out from your retirement accounts and you’re not at least age 59-1/2.
When it comes paying this penalty to Uncle Sam, there are two sides to the argument. Let’s dig right in.
Give people freedom to do as they wish
Some strongly stand by the idea that individuals should have full control of their retirement accounts. Afterall, it’s their money. So is it really so wrong to tap your account if you need the money? Would it be better to suffer when you need cash, perhaps to run up credit-card balances instead, while your 401(k) or 403(b) sits idly by?
When it comes to their hard-earned money, studies show that people have more restraint than they are given credit for. For example, when Congress waived the penalty on early distributions last year due to COVID-19, only 6.3% of eligible participants took advantage, according to Fidelity. That’s a small number considering people were given good reasons to tap into their retirement savings.
Proponents of removing early distribution penalty believe people facing financial hardships should decide when and how to use their retirement funds – not our lawmakers. They believe that 10 percent early withdrawal penalty should be waived permanently.
Restrict money until retirement
On the other hand, many believe that retirement funds are intended for golden years and should not be touched until the individual reaches normal retirement age. Proponents for the early withdrawal penalty argue that without proper financial literacy of planning, saving and investment, people are at more risk of making adverse financial decision, including not taking into consideration all sides before tapping into their retirement funds. For example, when individuals take money out early from their retirement accounts, they won’t have a chance to earn the return from now to their actual retirement date. Consider this: Those who took advantage of COVID penalty-free withdrawal last year lost the chance to boost their money during the strong run.
Example – penalty vs no penalty depending on age
| Under age 59-1/2 | Age 59-1/2 & older |
Total withdrawal | $50,000 | $50,000 |
20% mandatory withholding | $10,000 | $10,000 |
10% tax (normally calculated during tax return) | $5,000 | Waived |
Total net take-home | $35,000 | $40,000 |
As you can see, someone in the 20% tax bracket and under 59-1/2 pays an additional $5,000 in penalties.
Final words
So should people be dissuaded from taking early withdrawals by IRS continuing to impose this 10 percent penalty? Or should people be given complete autonomy to do as they please with their retirement money? We expect this debate heating up in the future. For now, one should weight pros and cons before depleting his or her retirement funds, especially if you’re under 59-1/2.
This is for educational purposes only. The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company’s benefits representative for rules specific to your plan.
About the Author
A 15-year veteran in all aspects of workplace retirement plan benefits program, Mizan J. Rahman is on a mission to help hard-working Americans enjoy a meaningful financial future. He specializes in the compliance, administration, design, and legal documentation of 401(k), 403(b), and 457(b) plans. Mizan provides high-level, personalized consulting to small businesses and not-for-profit organizations. One of the select few to have been awarded Enrolled Retirement Plan Agent (“ERPA”) by the Internal Revenue Service, Mizan regularly represents clients in front of DOL and IRS during audits.
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