Question: My wife and I (both public school teachers) purchased a home in August 2018. I took a hardship withdrawal from my tax-sheltered annuity (TSA) to pay for closing and renovation costs. I know I need to pay the taxes on the amount withdrawn, but there’s also a 10 percent penalty I must pay tax on, unless we qualify for an exception. The exception I thought we might qualify for is the “first-time homebuyer” exception. Although this isn’t my first home purchase it is my wife’s and both our names are on the purchase of the home. So my question is do I have to pay the taxes on the 10 percent penalty? thanks! – Luke in Virginia
Laura Adams, author, and host of Money Girl podcast responds…
If you’re thinking about raiding your retirement account early, or if you already took a TSA hardship withdrawal, it’s important to understand the rules. The regulations vary depending on the type of retirement account you have. I’ll cover the basics so you can prevent unexpected tax surprises and keep your retirement nest egg safe.
Understanding retirement accounts
First, here’s a brief explainer on retirement accounts. They were designed to encourage savings and to discourage you from dipping into them before retirement — or at least before reaching age 59½.
Retirement accounts give you terrific money-saving tax breaks, and they’re my favorite way to save for the future. However, if you break account rules, you’ll have to pay expensive taxes and penalties.
Retirement accounts aren’t piggy banks you can crack open anytime you want. Some have strict regulations that make it very difficult to get money out, even if you have a devastating financial hardship.
However, there are several qualified exceptions when you can take early distributions from retirement accounts that are penalty-free. The exceptions also depend on the type of account you have — such as an Individual Retirement Account (IRA) or a workplace retirement plan — and whether it’s a traditional or Roth account. Keep reading for more clarification.
Rules for making withdrawals from workplace retirement accounts
Many companies, nonprofits, and government agencies offer retirement accounts for workers. They’re a valuable perk to have, so be sure to participate if you’re eligible.
You’ve probably heard of a 401(k), which is a popular plan offered by many for-profit companies. It allows employees to have the employer contribute a portion of their wages to an individual account held by the plan.
[Find out how you can save more in your 401(k) this year.]
If you work for a public school, church, or charitable organization, you may have access to a 403(b) plan, also known as a tax-sheltered annuity (TSA). They’re similar to a 401(k) and also allow employees to put a portion of their wages into individual accounts.
Both a 401(k) and a 403(b) allow traditional and Roth options. With a traditional 401(k) or 403(b), you skip paying tax on contributions until you take withdrawals in the future. So tapping either type of traditional account early typically requires you to pay income tax, plus an additional 10 percent penalty, on amounts withdrawn.
With a Roth 401(k) or 403(b), you must pay income tax upfront on your contributions. That means you can make tax-free withdrawals in the future. However, distributions of any investment earnings would be subject to tax and a 10 percent penalty if you’re younger than age 59½.
Early withdrawal penalty exceptions for workplace retirement accounts
As I mentioned, there are some exceptions to the 10 percent early TSA hardship withdrawal penalty. In general, you can withdraw money from a 401(k) or 403(b) penalty-free for:
- Medical expenses that exceed 10 percent of your adjusted gross income and are not reimbursed by health insurance.
- Costs for military reservists called to active duty.
- Distributions made after leaving your employer after age 55.
If you have a traditional plan, you avoid the 10 percent penalty but must still pay ordinary income tax on early withdrawals. Unfortunately, there isn’t a penalty exception for using an early withdrawal from a workplace plan to purchase a home.
However, if you have an IRA, you can avoid the early withdrawal penalty for distributions up to $10,000 during your lifetime to purchase your first primary residence (or to buy a home after not owning one for two years). Again, this exception is only allowed for an IRA and not for any type of workplace retirement plan.
