Making an In-Service Withdrawal on Your Retirement

An in-service withdrawal on any retirement account is a withdrawal made before a qualifying event occurs. The most common qualifying event is age; for example, once you reach age 59-1/2, you are eligible to withdraw from a traditional IRA. You would pay taxes according to your retirement account. In the absence of a qualifying event, though, you will pay these taxes as well as a 10 percent penalty on the deduction. 

In-Service Withdrawal Example

A common example of an in-service withdrawal is an emergency withdrawal from an IRA. Frank lost his job three months ago. He has not been able to find work, and he has exhausted his savings. He is facing foreclosure on his mortgage if he cannot supplement his income this month. In order to make a mortgage payment, Frank takes an in-service withdrawal of $5,000 from his IRA. He pays a 10 percent tax of $500, and he pays the IRS income tax, according to his currently low tax bracket, of another $500. He can use the additional $4,000 to make his mortgage payment. This is an example of using an in-service withdrawal for the right reasons. The cost of the 10 percent penalty is far lower than the cost of a mortgage foreclosure.

Paying a Penalty

The amount of penalty you pay on an in-service withdrawal is always 10 percent, regardless of your tax bracket. However, you may have to pay a second payment like Frank did. This occurs when your retirement account, such as a traditional IRA, was built with tax-deductible contributions. Since you paid no taxes on the money when you put them in the account, you will have to pay taxes when you withdraw the funds. With a Roth IRA, you pay taxes up front, so you would not be liable for this same tax on the back end.

Qualifying Events

Depending on the type of retirement account you use, the qualifying events on your account will vary. All retirement accounts use age as a qualifying event, allowing you to withdraw funds at a certain point in your life without penalty. Some accounts, such as certain qualified plans, may also permit certain expenses to be withdrawn tax free. For example, the down payment to purchase a home may be withdrawn without penalty from some accounts. Cost to send a child to college may also be withdrawn. These withdrawals would still require the normal tax payment, but you would not be liable for the 10 percent penalty if they were permitted by your account.

Avoiding a Penalty

It is best to leave your retirement savings in the account rather than paying a 10 percent penalty to the IRS. In order to avoid this penalty, always have three months salary saved for emergency. Structure some of your savings in liquid accounts, such as cash savings accounts, that receive no special tax treatment. If you must take a loan from your retirement account, make sure the money is placed back into the account within the narrow window provided in order to prevent penalty for an in-service withdrawal.

In-Service Withdrawal

A withdrawal on a retirement account is an in-service withdrawal if it is made before a qualifying event. Typically, an in-service withdrawal is any made before the individual account holder reaches the minimum qualifying age of 59-1/2. Since the withdrawal is made early, the individual pays a 10 percent penalty in addition to taxes. There are a few types of in-service withdrawals where a penalty is not paid. These include withdrawals to pay for the down payment on a first home or for a college education for yourself or a dependent. In these cases, the money must be redeposited in the future.