IRA and 401(k) Basics: What Are Withdrawals vs Distributions?

The world of terms associated both with retirement finances as well as taxation can quickly seem overwhelming, which is why we’ve put together this primer. It’s intended to help you start to work through the differences between retirement account withdrawals and distributions; in our next post, we’ll tackle how these retirement accounts are taxed.

Since withdrawals and distributions are situations commonly encountered (or at least considered) at some point by nearly all retirement account holders, it can be helpful to understand what exactly each entails.

What is the difference between a withdrawal and a distribution?

There’s a difference between withdrawing from an IRA or 401(k) early and taking distributions from an IRA or 401(k) according to schedule.

You may have heard that you’ll pay a 10% penalty for taking money out of a retirement plan early. Actually, the rules get a bit more granular than this.

The easiest way to think about these rules is to consider removing money from your IRA in terms of three periods of life.

 

1. If you withdraw savings prior to turning 59 ½, you’ll almost certainly have to pay a penalty on top of taxes. This applies to all types of retirement accounts: Traditional, Roth (though, possibly without the taxes), SEP, and SIMPLE IRAs. This is also true from 401(k)s and similar account types. That penalty can vary depending on circumstances, like how long you had the account open and which account you are withdrawing from. But it usually sits at about 10%. There are some exceptions for things like medical expenses and disability, called a hardship withdrawal; we’ll get into this a bit later.
2. The second period of concern, especially in the eyes of the IRS, is between the ages of 59 ½ and 72. Before the recent passage of the SECURE Act, this range used to only go to 70 ½ years of age. Any withdrawals taken during this period are not penalized the fee mentioned in #1, but they are taxed according to the account type. Since Roth IRAs are set up to avoid taxes on withdrawals and distributions, you’ll pay taxes upon contribution; however, Roth IRAs have an added rule called the 5-year rule, where you have to be both 59 ½ and have held the account for at least five years before you can make withdrawals that are penalty-free and tax-free. For the other account types, you will incur a tax at your ordinary tax rate during the year you take the withdrawal.
3. The third period comes after the age of 72. Again, this was moved up from 70 ½ in the recent SECURE Act. The withdrawals work the same as they did in #2, except they are no longer optional. These are called required minimum distributions, or RMDs. The IRS requires a minimum amount of distributions from all IRAs after the age of 72.

How can I avoid penalties on withdrawals from my IRA or 401(k)?

The most obvious and important way to avoid the penalties that come with withdrawals is to avoid taking them (before you turn 72). Obviously, there comes times when needs outgrow wants—especially fiscally—so that might not always be possible and you might find yourself needing to take a withdrawal.

The first step if a withdrawal cannot be avoided is to look into penalty rules and exceptions. Once you are 59 ½, you won’t be penalized from taking money out of either a 401(k) or an IRA. If you can wait to avoid that penalty, that can have a significant effect on how much you’ll need to withdraw in the first place and how much you’ll have to pay in order to get your money.

Secondly, consider a retirement plan loan if you have a 401(k) or other similar employee-sponsored plan. The IRS provides solid information about this here, covering quite a bit about how loans on 401(k) and other employer-sponsored plans work. This money is not taxed as long as you adhere to the repayment terms and schedule. This might be an option for you to avoid early withdrawal penalties.

If you need to withdraw from your IRA, check to see if you are eligible for a hardship distribution, where you can have the 10% penalty waived on withdrawals made before you reach the age of 59 ½—as long as you will be using them in situations that meet certain conditions. For example, you are unemployed and meet specific eligibility criteria (e.g. you were let go, and did not voluntarily quit), you can use penalty-free distributions to cover your medical insurance premiums.

With IRAs (not so much with 401(k)s), there tend to be a wider range of situations that allow you to take penalty-free distributions. These can include withdrawals for divorces, qualified first-time home purchases, and even call to duty for military reservists. If you are considering an early withdrawal, it’s worth it to check your documentation or ask a professional and see if you qualify.

Another option that might be available to you is a substantially equal periodic payment (SEPP) program, which was designed for individuals who need some regular income before they turn 59 ½ (say, from a career that ended a bit earlier than expected). Unless you are trying to withdraw from a 401(k) plan that you hold with a current employer, you can use any qualified retirement plan/account with a SEPP plan. The IRS allows you to select how the distributions will be calculated, with the option to change methods once during the lifespan of the plan. If you cancel the plan before the minimum holding period, you’ll owe the waived penalties as well as interest, so if you choose this route, choose wisely.

Obviously, sometimes need dictates you withdraw from your savings early. But if it isn’t absolutely necessary, waiting for in-retirement distributions can be an extremely more beneficial decision, especially when dealing with penalties and taxes.

 

 

This article is intended to be purely educational; it is not intended as financial advice. For financial information pertaining to your particular situation, it is best to speak directly with a certified financial professional.