Individual retirement accounts and 401(k) plans often impose penalties if you take money out of a retirement account too soon or too late. There’s usually an early withdrawal penalty if you make a withdrawal before age 59 1/2 and a penalty for failing to take annual distributions after age 72. However, the CARES Act waives several types of retirement account fees in 2020 to help workers and retirees cope with the financial challenges of the pandemic. Here’s a look at the 401(k) and IRA penalties you won’t have to pay this year.
[Read: New Retirement Account Rules in Response to Coronavirus.]
The Penalty for Missing a Required Minimum Distribution
Annual withdrawals from 401(k)s and traditional IRAs are required after age 72, and the penalty for missing a distribution is a stiff 50% of the amount that should have been withdrawn. However, retirees will be permitted to skip their required minimum distributions in 2020 due to provisions of the CARES Act. Delaying your distributions gives your retirement account more time to grow and allows you to continue to defer paying income tax on your retirement savings. “If you can live without the required minimum distribution, it’s a great idea to skip it, as you won’t have to pay taxes on that money,” says Miguel Gomez, a certified financial planner at Lauterbach Financial Advisors in El Paso, Texas.
[Read: How to Skip Your Required Minimum Distribution in 2020]
The Early Withdrawal Penalty
Taking money out of a retirement account before age 59 1/2 usually triggers a 10% early withdrawal penalty. However, the early withdrawal penalty won’t apply to those who withdraw up to $100,000 to cope with coronavirus costs before Dec. 31, 2020. Those who test positive for COVID-19 or who have a spouse or dependent with the illness are eligible for penalty-free early withdrawals. You can also take penalty-free distributions if you experienced financial hardship as a result of the pandemic because you were laid off, quarantined, furloughed or unable to work because of a lack of child care.
However, retirement savers will still owe income tax on withdrawals from traditional 401(k)s and IRAs. A $1,000 early 401(k) withdrawal will result in $240 in taxes for someone in the 24% tax bracket. “Even though you may escape the penalty for 2020, you will still need to pay ordinary income tax on the amount you withdraw. You would also be reducing the amount of money that is able to grow to support your eventual retirement,” says Brad Wright, a certified financial planner and managing partner at Launch Financial Planning in Andover, Massachusetts. “Withdrawing money from a retirement account prior to being required to should be considered a last resort.”
[See: 11 Ways to Avoid the IRA Early Withdrawal Penalty.]
A Large Tax Bill in a Single Year
When you take a distribution from a traditional retirement account, income tax will be due on the amount you withdraw. If you take a 401(k) withdrawal to cope with an emergency expense, you could end up with an abnormally large tax bill at the end of the year. For example, a $25,000 401(k) distribution could trigger a $6,000 tax bill for someone in the 24% tax bracket. However, the CARES Act allows you to pay the 2020 income tax bill over a three-year period. Instead of facing the $6,000 tax bill in a single year, you could pay $2,000 per year over three years. “More than likely, most people will spread it out over three years, which will give them more time to pay it back,” says Greg Brown, a certified financial planner for Pathway Financial in Novi, Michigan. “The downside is this longer payback window requires filing amended returns, which likely means hiring a tax professional.”
Retirement savers who take a coronavirus emergency withdrawal also have the option to put the money back in a retirement account within three years of the distribution. “Returning the money back into your retirement account means you’ll have to amend your tax returns and potentially get a refund,” says David Flores Wilson, a certified financial planner and managing partner at Sincerus Advisory in New York City. Income tax can be deferred on money that is returned to a 401(k) or IRA.
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401(k) and IRA Penalties That Don’t Apply in 2020 originally appeared on usnews.com
