Get to know the authorIt’s usually not ideal to withdraw from retirement accounts before you reach retirement age. For one, withdrawing these funds early means you miss out on the exponential tax-free growth they can accrue over decades. What’s more, the IRS levies both a 401(k) early withdrawal penalty and an individual retirement account (IRA) early withdrawal penalty.
With that said, we understand that life happens. Whether you need cash on hand for medical expenses, a down payment on a home, or necessary car repairs, you may have to withdraw retirement funds early at some point in your life. In situations like this, thoroughly understanding early withdrawal penalties can help you mitigate their impact.
Wondering how to withdraw money from retirement accounts early without racking up major fines? Read below as we detail what early withdrawal penalties are, which accounts they affect, how you can minimize their impact, and more.
What are early 401(k) & IRA withdrawal penalties?
Early withdrawal penalties are fines imposed by the IRS on distributions from qualified retirement accounts received before a certain age. These IRA and 401(k) withdrawal rules are in place to discourage the use of retirement funds on anything other than retirement.
The standard penalty for early withdrawal from a retirement account is 10% on any funds withdrawn before the age of 59 ½. That said, there are certain exceptions which we’ll discuss more in a bit. This penalty applies to most pre-tax retirement accounts, including:
- 401(k)s
- 403(b)s
- Traditional IRAs
- SEP IRAs
- Simple IRAs
- Profit-sharing plans
Note that this penalty does not apply to 457(b) plans unless they contain funds received through a direct transfer or rollover from a qualified retirement plan.
Post-tax accounts
Early withdrawal penalties for post-tax accounts like Roth IRAs and Roth 401(k) plans work slightly differently. Unlike the accounts mentioned earlier, contributions to Roth accounts come from post-tax dollars.
As a result, you can withdraw the contributions you have made without penalty. However, withdrawing any investment growth on contributions will incur a 10% penalty unless a) you’ve reached the age of 59 ½ and b) the account has been open for at least five years.
Note:
Although these rules apply to both Roth IRAs and Roth 401(k)s in theory, specific guidelines for early Roth 401(k) withdrawals may vary depending on your employer’s plan.
Example: James is a 34-year-old US expat who has made $9,000 in contributions to a Roth IRA over the years. The contributions he invested have since increased in value by $6,000, so the Roth IRA is now worth $15,000 total. James may withdraw up to $9,000 from his Roth IRA without penalty, but anything over that will be subject to a 10% fine until he reaches 59 ½.
Exceptions to 401(k) & IRA early withdrawal penalties
There are some circumstances in which you may be able to make early withdrawals from retirement funds without penalty. For example, you can make early withdrawals from 401(k)s, 403(b)s, and other non-IRA plans without penalty if you:
- Become unemployed at age 55 or later (age 50 for public safety employees covered under a government plan)
- Have accrued tax-deductible, unreimbursed medical expenses exceeding 7.5% of your adjusted gross income (AGI)
- Are the beneficiary of an account after the original account holder’s death
- Take a distribution (up to $1,000 or the vested account balance over $1,000 — whichever is smaller) no more than once per calendar year for personal or family emergency expenses
- Take less than $5,000 per parent for a qualified birth or adoption
- Become totally & permanently disabled
- Are terminally ill
- Take the distribution as part of a series of substantially equal periodic payments (SEPPs)
- Receive dividend distributions as part of an employee stock ownership plan
- Become unemployed as a former firefighter who has reached age 50 or 25 years of service (whichever comes first)
- Take the distribution to pay off an IRS fine
- Are the spouse or former spouse of the original account owner receiving a distribution as part of a qualified domestic relations order (QDRO)
- Take the distribution as part of a phased retirement annuity payment plan made to federal employees
- Take a tax-free distribution (up to $22,000) as the result of a federally declared emergency or disaster
- Were grandfathered into penalty-free early distributions according to a written election made for an employer-sponsored plan as of March 1, 1986
- Are a victim of domestic abuse (up to $10,000 or 50% of the account — whichever is greater)
- Take a qualified reservist distribution as an individual who was called to active duty for at least 180 days after September 11, 2001
Note:
Some plans allow for hardship distributions/hardship withdrawals. Under these rules, you can make early withdrawals if you take only the amount necessary in response to an immediate and significant financial need. However, these distributions are generally still subject to a 10% early withdrawal penalty.
There are however, a few additional early withdrawal penalty exceptions carved out for IRAs, including for:
- Health insurance premiums after you have received — or would have been eligible to receive — unemployment compensation
- Note: Must have been unemployed for at least 12 weeks
- Qualified higher education expenses
- First-time home purchases (up to $10,000)
- Corrective distributions, aka distributions made to compensate for previously exceeding contribution limits
Tax implications of early 401(k) & IRA withdrawals
US tax implications
In addition to potential penalties, early distributions from tax-deferred retirement accounts — like 401(k)s and traditional IRAs — are generally taxable. Whatever amount you withdraw will be added to your taxable income, which incurs ordinary tax rates (10% to 37%, depending on your overall taxable income).
Example: Maya is a US expat who earned $120,000 in 2023. She withdrew $20,000 from her 401(k) to help her afford the down payment on a flat in London. The IRS will charge her a 10% penalty ($2,000), and she must add the $20,000 she withdrew to her overall taxable income for a total of $140,000.
Before applying any tax credits, deductions, or exclusions, Maya’s federal income tax liability is $28,998: $26,998 in income taxes plus a $2,000 penalty for cashing out her 401(k) early. If she hadn’t made the early withdrawal, her tax liability would have been just $22,200.
Note that early withdrawals from a traditional IRA differ from early withdrawals from a Roth IRA. Early Roth IRA distributions are subject to a 10% early withdrawal penalty only if they exceed your total contributions. What’s more, they are not included in your overall taxable income. Again, this is because Roth IRA contributions come from post-tax dollars.
Reporting early withdrawals
After making an early withdrawal from a retirement plan, you must report it on Schedule 2 (Form 1040). You may also need to file Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts, if:
- The distribution is subject to the penalty and you don’t see distribution code 1 in the appropriate box on Form 1099-R
- An exception to the penalty applies to the distribution, but you don’t see a distribution code 2, 3, or 4 in the appropriate box on Form 1099-R
International tax implications
Depending on the country and your tax residency status, early withdrawals from a US retirement account may be subject to taxes in your country of residence as well.
In most countries, tax residents are subject to taxation on their worldwide income, which could potentially include an early withdrawal from a retirement account. Non-tax residents, on the other hand, are often not required to pay taxes on foreign-sourced income.
However, it all depends on the tax rules in your specific country — so make sure to look them up before making an early withdrawal. And fortunately, even if you are subject to international taxes on an early withdrawal from a US-based retirement plan, there are ways to mitigate these taxes.
Strategies for minimizing 401(k)/IRA early withdrawal penalties as an expat
Given the risk of early withdrawal penalties and missing out on future growth, it’s often best to avoid withdrawing from your retirement funds until you reach the qualifying age.
If you’re thinking of how to withdraw from your retirement account early, you might want to consider an alternative. This could include taking out a loan, borrowing from a family member, withdrawing from another brokerage account, or picking up a side gig, among other ideas.
That said, if you absolutely can’t avoid making an early withdrawal, you can minimize the damage by:
- Withdrawing from your Roth IRA only: As we discussed earlier, you can make penalty-free withdrawals from your Roth IRA at any time as long as you withdraw no more than what you’ve already contributed. Doing so won’t even increase your taxable income.
- Making a Roth conversion: If you know you’ll need to borrow from your retirement in the near future, you might consider converting funds from a traditional IRA to a Roth IRA. While you’ll have to pay taxes to convert your pre-tax traditional IRA funds into post-tax Roth IRA funds, it can help you make penalty-free, tax-free withdrawals in the future.
- Taking advantage of expat tax benefits: US expats who are tax residents of other countries may be able to reduce or even eliminate the risk of double taxation by:
- Claiming the Foreign Tax Credit (FTC): If you must pay income taxes on your retirement withdrawal in your country of residence, claiming the FTC will help offset your US tax liability by giving you dollar-for-dollar credits on foreign income taxes.
- Claim the benefits from a tax treaty: The US has tax agreements with dozens of other countries that aim to eliminate double taxation. While a saving clause typically eliminates most of the benefits for US expats, each treaty usually has at least some exceptions.
- Note: Students, trainees, researchers, and educators are especially likely to be able to benefit from a tax treaty.
- Leveraging the Foreign Earned Income Exclusion (FEIE): The FEIE allows qualifying US expats to exclude up to $120,000 (2023) or $126,500 (2024) of foreign-earned income from taxation. While you won’t be able to directly apply the FEIE to an early retirement withdrawal, it can help you decrease your overall tax liability.
Optimize your tax strategy with Bright!Tax
If you must make an early withdrawal from retirement savings, it’s important to understand the 401(k) and IRA account withdrawal rules.
Early withdrawals from pre-tax retirement accounts typically lead to penalties, although there are some exceptions. Withdrawals from Roth IRAs are typically penalty-free and even tax-free if you withdraw less than what you’ve contributed. That said, the funds you withdraw won’t be able to appreciate in value over time like they would otherwise.
Coming up with an optimal tax strategy is always important, but this is especially true if an early retirement withdrawal will increase your tax liability.
Resources:
- Topic no. 558, Additional tax on early distributions from retirement plans other than IRAs
- Roth IRA Withdrawal Rules
- Retirement topics – Exceptions to tax on early distributions
- Retirement topics – Hardship distributions
- Topic no. 557, Additional tax on early distributions from traditional and Roth IRAs
- IRS Form 5329: Reporting Taxes on Retirement Plans
