Question: I am inquiring about withdrawing funds from a 401(k) for moving and fellowship expenses. I was wondering if fellowship education counts as an exception to the 10 percent penalty, and if rolling it into an IRA would be a better option first? Thanks!
— Emily in Iowa
Jacob Dayan answers…
These are great questions related to retirement accounts, and I will warn you in advance: The answers can get a little complicated. I will also warn you that this information is generally applicable, but you might want to consult a professional, since every tax situation is different.
[Community Tax co-founder Jacob Dayan]
Hi, I’m Jacob Dayan, CEO and co-founder of Community Tax.
A 401(k) is a powerful tool for your retirement. Not only are you contributing to your own future tax- free, but in many cases, your employer matches some of your contributions. That’s free money. But sometimes, you might need to tap that retirement account right now.
If you take money out of your 401 (k) before you turn 59 ½ years old, you face a 10 percent penalty. However, there are exceptions to paying that steep fee. One of those exceptions is for furthering your education. Other exceptions include buying your first home, medical expenses, or military service.
But deciding when to take an early withdrawal, or even if you should do it, isn’t a decision to make lightly. I recommend consulting an expert first. They can tell you if the math adds up, and they might even be able to find you another way to cover the cost of whatever you’re looking at. Call Debt.com for a free consultation.
The rules for withdrawing early
First, let’s explain what you already know: If you contribute to a 401(k) and take out money before you turn 59 1/2 years old, you might be hit with a 10 percent federal tax penalty.
(As just one example of how this is already complicated, if you left your employer and you’re 55 years old or older and then took out some money, you might not have to pay the penalty.)
Now let’s review the exceptions to this rule. There are quite a few. For example, if you’re buying your first house, you can take out $10,000 without paying a penalty. (It’s actually $20,000 for couples.) There are also exceptions for medical expenses, disability, and even military service.
The closest to Emily’s circumstances is probably something called “Qualified Education Expenses.” That’s a fancy way of saying, “money paid to a legitimate college for your education or the education of a close family member.”
As you can probably tell, these exceptions are intended to help you out of a jam or make you a more valuable and productive citizen. The educational exception falls into the latter.
So the only way Emily’s “fellowship expenses” will count under this exception is if the expenses are used for her education.
Rolling a 401(k) into an IRA
A withdrawal from an IRA can be a great way to make a sizable payment toward back taxes. However, withdrawals from an IRA are taxed the same way a regular paycheck is taxed — and it may even be subject to an additional 10-percent tax penalty if you’re younger than 59 1/2 years old. In considering this option, make sure to consider the tax on the withdrawal and that you’re not just trading one tax problem for another.
As you can tell, there’s not one easy answer when it comes to tapping a retirement account early. The federal government does this on purpose — it wants to encourage Americans to save for retirement, so it defines a few narrow exceptions and makes you work for them.
It’s difficult to advise someone without knowing more about their financial picture other than their retirement accounts. That’s why consulting an expert will often save you much more than it costs — and that’s what Debt.com is here for.
Jacob Dayan is co-founder of Community Tax LLC, a full-service tax company helping customers nationwide with tax resolution, tax preparation, bookkeeping, and accounting.
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