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Retirement Account Withdrawals

Can I use my 401(k) and profit-sharing accounts to pay off my house without the 10% penalty? If so, will I have to pay income tax on this?

–John, Kentucky


Withdrawals from 401(k), profit sharing, and other retirement accounts before age 59½ are, with few exceptions, subject to a 10-percent early withdrawal penalty. In addition, withdrawals from retirement accounts at any age are usually subject to income taxes.

There are, however, two exceptions:

  • Most withdrawals from Roth IRAs and withdrawals of the portion of total retirement account balances attributable to after-tax contributions (such as nondeductible IRA contributions) are not subject to income taxes.

 

  • Using retirement account money to pay off a home mortgage or other loans may seem like a good idea. After all, being debt-free makes retiring comfortably a lot easier. But using retirement account money to make a sizable loan payment is usually not a wise decision because of the heavy taxes you would incur by doing so.


Here’s an example: John Doe owes $100,000 in mortgage and other debt and has more than enough money in his retirement account to pay off the loans. But in order to do so, he would have to pay a hefty tax bill under any circumstances. To boot, since the money withdrawn is added on top of other taxable income, the withdrawal could put him in a higher income-tax bracket. In this example, because John has other income, the withdrawal from the retirement account would cause him to incur taxes at the rate of 28 percent.

In the 28-percent bracket, in order to have $100,000 left over after taxes to pay off the loans, John would need to withdraw almost $140,000. (This is if, as is usually the case, all of the money withdrawn was subject to income taxes.) Multiplying $140,000 by 28 percent equals almost $40,000 in taxes, with $100,000 left over after taxes. I assert that paying $40,000 in income taxes is a heavy price tag for the privilege of freeing up the $100,000. A better strategy would be to withdraw the money more gradually to pay down the debt, allowing the retirement account money a chance to grow tax-deferred in the future.
 
Even though I added our income tax refund check this year to our Roth IRA, can we still withdraw money monthly next year to pay our health insurance when we retire? We will both be 60 at that time.

–Denise, Iowa


While the rules pertaining to Roth IRA withdrawals are rather complicated, your situation is relatively straightforward. Generally, money originally contributed to a Roth IRA can be withdrawn at any time without having to pay taxes or penalties. There is a rule that can subject any earnings made on Roth IRA investments to income taxes. If the money is withdrawn under age 59½, there are penalties if the withdrawal is made within five years of the original contribution or conversion. But the five-year rule does not apply to withdrawals of contributions.

The IRS has a helpful guide that describes the various rules pertaining to withdrawals from and contributions to both Roth and traditional IRAs. The guide also includes information on any recent or future changes to the rules. You can download IRS Publication 590, Individual Retirement Arrangements, by visiting www.irs.gov/publications/p590/index.html.
 

All the information presented on AARP.org is for educational and resource purposes only. We suggest that you consult with your financial or tax adviser with regard to your individual situation. Use of the information contained in this Web site is at the sole choice and risk of the reader.

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