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SSDI Evaluation

Tapping Into Retirement Savings

Ideally, you will have at least some personal savings to help support you while you await your SSDI benefits.

Many people either don't have adequate funds or quickly deplete their general savings. As a result, they may tap into their IRAs, 401(k) or other retirement plans available. Often this can't be avoided, but there are a few things you should know about withdrawing from these accounts prior to retirement.

An important downside is that taxes and penalties could eat up to half of the withdrawal amount. In other words, a $10,000 withdrawal may not equal $10,000 in your pocket.

 
Example:
Let’s say you are under the age of 59½, the age at which you can begin making penalty-free withdrawals from the account. You are in the 28 percent tax bracket, and you take a $10,000 withdrawal that does not qualify for any of the exceptions to the 10 percent early withdrawal penalty.
 
$10,000 withdrawal
 $2,800 – income tax
 $1,000 – 10 percent withdrawal penalty
  $6,300 – or less when factoring in state and local taxes
 

The pain of dipping into retirement funds early includes:

  • Assessment of income tax on the withdrawal at your current tax rate
  • Assessment of 10 percent early withdrawal penalty
  • Reduces the amount of assets available to sustain you in retirement
  • Reduces tax-free compounding of interest that makes investments grow

Steps in deciding whether to take an early withdrawal from a qualified retirement plan account

  • If at all possible, seek the advice of a professional tax advisor for help in making the decision.
  • Carefully review your retirement plan documents or IRA adoption agreement. It is not legally mandatory that plans offer hardship withdrawals or loans, so you will want to read the details of your plan's allowances. Will you qualify for any exceptions to the 10 percent early withdrawal penalty?
  • Find your plan's definition of "disability" as it may differ from that of the Social Security Administration. You may be able to qualify for a waiver of the 10 percent early withdrawal penalty if you can prove that you are disabled under the plan's definition.
  • You will want to estimate the amount of tax and the penalty you may owe as part of the decision-making process. Work through IRS Form 5329 and its instructions to determine how much you'll owe. [LINK] http://taxes.about.com/od/retirementtaxes/a/early_penalty_2.htm
  • You must be prepared to prove that you have no other resources available as part of qualifying for an early retirement account withdrawal or loan.

Taxes, Penalties and Borrowing Options when you are under Age 59½

The income tax, penalty assessments and borrowing options vary depending on what type of plan you have.

Individual Retirement Accounts - IRAs
401(k) and 403(b) Plans

 Individual Retirement Accounts - IRAs

Roth IRA

  • Your contributions to the account may be withdrawn at any time without penalty or income tax after age 59½ since they already have been taxed.
  • All withdrawals of earnings on the account investments will be subject to tax.
  • Five-year holding period - all withdrawals are assessed with both income tax and the 10 percent early withdrawal penalty if the account was open for less than five years.
  • All withdrawals before age 59½ will be subject to a 10 percent penalty unless you fall into one of the categories of exceptions to the penalty.
  • Traditional IRA converted to Roth IRA - You will not owe the income tax, but you will owe the 10 percent penalty for an early withdrawal. The five-year holding period also applies.

Traditional IRA

  • All distributions will be subject to income tax at your current tax rate since the funds were not taxed at the time of contribution to the plan.
  • If you are under age 59½, you also will get hit with the 10 percent early withdrawal penalty unless you fall into one of the categories of exceptions to the penalty.
  • Inherited IRAs - Generally, you will pay ordinary income tax on the amount withdrawn, however, the 10 percent penalty will not apply.

 Exceptions to the 10 percent early withdrawal penalty for Traditional and Roth IRAs

  • Permanent disability or death of the account owner
  • Payment of health insurance premiums during unemployment
  • Unreimbursed medical bills equaling at least 7.5 percent of your adjusted gross income
  • Qualified higher education expenses - tuition, books, fees, etc.
  • First time home purchase - up to $10,000
  • IRS levy for tax debt
  • If you are under age 55, separated from service and have set up a payment schedule to make substantially equal withdrawals over your life expectancy.
  • A court of law has ordered a distribution under a divorce decree or separation agreement (a QDRO, or qualified domestic relations order).

Borrowing against IRAs

The IRS does not allow you to borrow against your IRA. However, there are some options to help in the short term.

  • If you made a contribution to an IRA this year, you can make a withdrawal in the same year equal to the amount of your contribution - provided you return it by April 15 of the following year. The "loan" amount will be subject to income tax at your current rate plus the 10 percent early withdrawal penalty.
  • You can take a short-term "loan" by withdrawing funds from your IRA for 60 days. If you fail to replace the money within the 60-day period, you will be subject to income tax at your current rate (traditional IRA only) plus the 10 percent early withdrawal penalty.
  • Convert a traditional IRA to a Roth IRA - You must transfer all funds from the traditional IRA account to the new Roth IRA account within 60 days. You can use the 60-day conversion period as a short-term loan, but be sure to get the funds deposited into the new Roth account within the 60-day time limit, or you will be subject to income tax and penalty on the full value of the account.

 401(k) and 403(b) Plans

  • All distributions will be subject to income tax at your current tax rate since the funds were not taxed at the time of contribution to the plan.
  • If you are under age 59½, you also will get hit with the 10 percent early withdrawal penalty unless you fall into one of the categories of penalty-free hardships.
  • Some plans will require that all efforts to obtain a loan against the plan are exhausted before granting a hardship withdrawal.

Hardship withdrawals that qualify for the 10 percent early withdrawal penalty waiver

  • Disability as defined by your plan documents
  • Medical expenses exceeding 7.5 percent of adjusted gross income
  • Separation from service at age 55 or later due to permanent layoff, termination, early retirement or quitting
  • If you are under age 55, separated from service and have set up a payment schedule with your plan administrator to make substantially equal withdrawals over your life expectancy.
  • A court of law has ordered a distribution under a divorce decree or separation agreement (a QDRO, or qualified domestic relations order).

Hardship withdrawals that do not qualify for the 10 percent penalty waiver

  • Unreimbursed medical expenses for you, your spouse or dependents
  • To avoid eviction from your residence or foreclosure
  • Payment of one-year's college tuition and expenses
  • Home purchase or repair - up to $10,000
Of note for 403(b) plans:
Hardship withdrawals are available only if you enrolled in the plan before
Dec. 31, 1988, and the funds available for withdrawal are only those contributed before Dec. 31, 1988. 

Borrowing from your 401(k) and 403(b) Plan

  • You can only borrow from these plans while you are employed by your plan's sponsor.