What are the tax consequences of an early withdrawal from a Simple IRA?

A SIMPLE IRA, also known as a “Savings Incentive Match Plan for Employees” is most common among small employers who have less than 100 employees. When Congress created SIMPLE IRAs, it intentionally imposed harsh penalties on early withdrawals because this type of retirement plan is specifically designed to force lower wage workers to save for retirement. Small employers offer SIMPLE IRAs because there are no start-up operating costs or filing requirements. Employers are required to contribute to the employee’s SIMPLE IRA each year. Employees are also eligible to contribute to the plan. Unlike other retirement plans, loans against the value of a SIMPLE IRA are not permitted.

Tax Consequences of Early Withdrawals from SIMPLE IRAs

The tax consequences of distributions or withdrawals from a SIMPLE IRA will vary based on the age of the employee. They are also based on how long the employee has participated in the retirement plan. Anytime funds are withdrawn from a SIMPLE IRA, and the employee is under the age of 59 ½, it is considered an early withdrawal.

In addition to taxing early withdrawals as ordinary income to the employee, the IRS imposes additional taxes as penalties for taking an early withdrawal. These additional taxes on early withdrawals are designed to discourage employees from taking money out of their retirement plans. However, there are exceptions to the additional taxes if the employee is taking the early withdrawal for certain reasons.

Exceptions to Early Withdrawal Tax Penalties

If the early withdrawal is used to pay for unreimbursed medical expenses, medical insurance, and higher education expenses, employees are not subject to the additional tax. The additional tax is also not imposed if the employee is disabled or needs the money to purchase, rebuild, or build a first home. In addition, if the employee dies before reaching age 59 ½, the funds in the SIMPLE IRA can be distributed to the beneficiaries without the early withdrawal penalty. Finally, the early withdrawal penalty will not apply if the withdrawal is rolled over into another IRA plan within 60 days after the employee receives the distribution from the SIMPLE IRA.

Understanding Tax Penalties for Early Withdrawal

Early withdrawals are considered income to the employee and taxed at the employee’s tax rate with an additional 10 percent penalty tax. For most people, making an early withdrawal means losing up to 30 percent of the amount withdrawn in taxes. If an employee has participated in the SIMPLE IRA for less than two years, the additional 10 percent penalty tax is increased to 25 percent. This means that in addition to paying regular income tax, the employee will also have to pay an additional 25 percent penalty tax for making an early withdrawal from his simple retirement plan.

Sample Tax Penalties for Early Withdrawal from SIMPLE IRA

Assume Ted who is 28 years old has worked at his job for 1 year and 3 months. Both Ted and his employer have contributed $500 each to his SIMPLE IRA, giving him a total vested value of $1,000. Being vested in a retirement account simply means that the employee has complete ownership of the funds in the account. Employees are always 100 percent vested in SIMPLE IRAs. Let’s assume further that the $1,000 contributed to the SIMPLE IRA increased in value to $1,250 during the time Ted has been with his employer. Unfortunately, Ted’s home gets flooded and he does not have flood insurance, so he has to pay out of pocket for repairs to his home. Ted may look to his SIMPLE IRA for the funds necessary to fix his home.

Based on Ted’s annual income, he falls in the 20 percent income tax bracket and if he takes an early withdrawal from his SIMPLE IRA, he will have to pay an additional 25 percent in tax because he has participated in the plan for less than two years. This means that 45 percent of the value of the funds will be deducted up front when Ted takes the early withdrawal. Ultimately, of the $1,250 in his SIMPLE IRA, Ted will only get $687.50.

Early Withdrawal from a SIMPLE IRA – Making the Final Decision

Unless you qualify to take the money out of the SIMPLE IRA under one of the exceptions, those employees thinking of making an early withdrawal should consider whether losing part of their retirement savings to taxes outweighs the immediate need for cash. They should also consider all alternatives to withdrawing funds from this type of retirement plan.

Tax Consequences of Early Withdrawal From a Simple IRA: Case Studies

Case Study 1: Emergency Home Repairs

Ted, a 28-year-old employee, has been contributing to a Simple IRA for 1 year and 3 months. His home gets flooded, and he needs immediate funds for repairs. He considers taking an early withdrawal from his Simple IRA. However, Ted falls into the 20% income tax bracket and has participated in the plan for less than two years. This means that he would face a 25% additional tax penalty on the early withdrawal. If Ted decides to withdraw $1,250 from his Simple IRA, he would only receive $687.50 after deducting the 45% in taxes and penalties. Ted consults with a financial advisor to explore alternative options and assess whether the tax consequences outweigh the immediate need for cash.

Case Study 2: Medical Expenses

Mary, a participant in a Simple IRA, incurs significant medical expenses that are not fully covered by her insurance. She considers taking an early withdrawal from her retirement account to cover these expenses. However, since the early withdrawal is used to pay for unreimbursed medical expenses, Mary is exempt from the additional tax penalties. While she will still have to pay income tax on the withdrawn amount, she can avoid the extra tax penalties associated with early withdrawals. Mary consults with a tax professional to understand the tax implications and ensure compliance with the IRS rules regarding medical expense withdrawals.

Case Study 3: First-Time Home Purchase

John, a 35-year-old employee who has been contributing to a Simple IRA for several years, decides to purchase his first home. He needs additional funds for the down payment and considers taking an early withdrawal from his retirement account. Fortunately, the IRS allows penalty-free withdrawals from a Simple IRA for qualified first-time home purchases. John consults with a tax advisor to understand the documentation and requirements needed to ensure that the withdrawal qualifies for the exemption. By following the proper procedures, John can avoid the additional tax penalties on the early withdrawal and use the funds towards his home purchase.