5 Retirement Penalties to Avoid

Sidestep these retirement taxes and fees with advance planning.


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By Emily Brandon

If you take money out of your 401(k) or individual retirement account too soon or too late, you'll be penalized. There are also penalties if you claim Social Security and Medicare benefits early or late, respectively. Take care to avoid these five significant retirement penalties:

IRA early withdrawal penalty. If you withdraw money from your IRA before age 59½, you will generally have to pay a 10 percent early withdrawal penalty in addition to income tax on the amount withdrawn. So, if you withdraw $5,000 from your IRA at age 40, you'll need to pay a $500 tax penalty. However, there are a variety of ways to avoid the 10 percent penalty. If you use the money to pay for college costs or purchase a first home (up to $10,000), the penalty doesn't apply. You don't need to pay the penalty if the distribution is for some specific circumstances, including significant medical expenses that exceed 10 percent of your adjusted gross income, purchasing health insurance after a layoff or paying for expenses associated with a significant disability. You can also set up a series of annuity payments from your IRA without incurring the 10 percent penalty.

Roth IRA owners can withdraw the contributions, but not the earnings, from accounts that are at least five years old without incurring the early withdrawal penalty. "If you have a Roth, that might give you the ability to get at that money penalty-free," says Eleanor Blayney, a certified financial planner and the CFP Board's consumer advocate. "You can withdraw without penalty if it's money you contributed yourself."

401(k) early withdrawal penalty. The age the early withdrawal penalty ends for 401(k) participants is also age 59½. However, if you leave your job at age 55 or older (or age 50 for public safety employees),

you can take penalty-free 401(k) withdrawals from the 401(k) associated with that employer beginning at age 55. Unlike IRAs, 401(k)s often allow you to take a loan from the account without incurring the early withdrawal penalty. However, if you lose or leave the job before the loan is paid off, the loan typically becomes due, and if you don't pay it back, the early withdrawal penalty may apply. "You can take a loan from a 401(k), assuming that your plan allows it, but that can be a little bit dangerous for some people because if you lose your job or leave the employer where the 401(k) plan is, you would have to pay it back," Blayney says. "If you can't pay it back, the amount outstanding becomes an early distribution subject to penalty."

Penalty for failing to take retirement distributions. After you turn age 70½, withdrawals from traditional 401(k)s and IRAs are required. You can add up the required minimum distributions for all your IRAs and take the amount out of any IRA or combination of IRAs of your choice. Meanwhile, 401(k) RMDs must be taken from each individual account to avoid the penalty. "If you have five IRAs, you can satisfy the IRA distributions from any of the IRAs, but if you have three other old 401(k)s from companies where you are not working anymore, you have to take it from each 401(k)," says Howard Hook, an accountant and certified financial planner for EKS Associates in Princeton, N.J. Those who fail to withdraw the correct amount are charged a steep 50 percent tax penalty in addition to regular income tax on the amount withdrawn. However, if you are still working and don't own 5 percent or more of the company you work for, you can delay required minimum distributions from your current 401(k), but not your IRAs or any previous 401(k)s, until April 1 of the year after you retire.

Your first required minimum distribution is due by April 1 of the year after you turn 70½, but subsequent distributions must be taken by Dec. 31 each year. If you delay your first distribution, you may need to take two distributions in the same year. "We normally say tax deferral is what you want, but taking two distributions could throw you into a higher tax bracket," Hook says. "Taking a second distribution may cause certain deductions to be lost or reduced or make more of your Social Security income taxable." There are no withdrawal requirements for Roth IRAs, so the money can be withdrawn as you see fit or left to heirs.

Early Social Security penalty. You can receive the full amount of Social Security you have earned at age 66 for most baby boomers and age 67 for everyone born in 1960 or later. Signing up before this age results in a significant reduction in benefits. For example, a worker born in 1965 who signs up for Social Security at age 62 will get 30 percent smaller payments for the rest of his life than if he waited until age 67 to sign up. "I think most people should find ways to delay it until later, as long as they are healthy and have a reasonable possibility of living into old age," Blayney says.

Medicare late enrollment penalties. There's a seven-month window around your 65th birthday when you can first sign up for Medicare Part B. If you fail to enroll during this period, your monthly premiums will increase by 10 percent for each 12-month period you were eligible for benefits but didn't claim them, and the higher premiums will last for the rest of your life. If you're still working after age 65 and get group health coverage through your job, you will need to sign up within eight months of leaving the job or losing the coverage to avoid the penalty.

"For most people, it's pretty important to sign up for Part B when you are first eligible because if you don't do it, the penalty for signing up late is quite substantial," says Jack Hoadley, a health policy analyst at Georgetown University. Medicare Part D also has a late enrollment penalty if you don't sign up on time or have significant gaps in your prescription drug coverage after becoming eligible for Part D, and the penalty increases the longer you go without coverage. Also, if you miss the six-month Medigap initial enrollment period that begins the month you turn 65 and enroll in Part B, you could lose the option to buy a Medigap policy, or it could cost significantly more than if you signed up on time.

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Everything written above is such a old explanation now. Who doesn't even know how to avoid all tax penalties in Retirement. I read this like two years ago in 2012 and it is written as the same explanation back than.. WORD-FOR-WORD.

March 09 2014 at 5:19 AM Report abuse +1 rate up rate down Reply

Yeah this is why I invest some of my money in whole life insurance.

Its tax deferred and you can withdraw cost basis first so no taxes.

Just find a cheap policy from a quote comparison site like LifeAnt. Its a great alternative to 401k for part of your retirement savings.

March 05 2014 at 11:20 PM Report abuse rate up rate down Reply

My tips -
1) Work longer, at least in occupations where modern health allows. Coal miners still get a pass, in other words. Pay in a bit more, take out less.
2) Save - make money of some stability and interests rates that reflect that. So there will not only be investment, but non-financial investment, which is where the growth occurs.
3) Invest in Life Insurance - Protect your family. I pay 50/month for 2 million in benefits from LifeAnt.. and it pays dividends
And means test our regulations. Not all produce net benefits. Also there are many where the benefit is protection for some group of haves, but the cost goes to various have-nots. Reverse progressive redistribution.

March 05 2014 at 10:59 PM Report abuse rate up rate down Reply

Other not so obvious "penalties" include not starting to plan and save/invest early in life, not taking advantage of employer matching plans, not maxing out contributions, not taking advantage of catch up contributions when turning 50, not reducing or eliminating debt, etc. There is some great information on retirement investing on the site Retirement And Good Living which also provides information on health, retirement locations, travel, part time jobs, volunteering and more. And it has a blog of posts by guests from around the globe on many retirement topics.

March 05 2014 at 7:05 AM Report abuse rate up rate down Reply

Too bad we can't avoid the cost of Obamacare. My last medical procedure cost me more because of it.

March 04 2014 at 1:06 PM Report abuse -1 rate up rate down Reply

Be careful about when you take money out an IRA, I thought it was okay to take money out in the year that you turned 59 1/2 and took out money just 2 month before I turned 59 1/2. I was hit with a 10 % penalty. Of course there is an issue of when one turns 59 1/2. Is it 59 and six months or 59 and 183 days or 59 and 26 weeks? These milestones are not the same. Better to be safe than sorry and wait a few days.

March 04 2014 at 12:46 PM Report abuse +1 rate up rate down Reply

Like Social Security's still going to be around. I'm 53 and have no plans to retire early, but I have to wait until age 66 years, 8 months to receive full benefits. My heart's been in A-fib occasionally for 2 years now, and 15 years is starting to look like a very long time. I have a money market-based private retirement plan set up, as well as a state pension. Hope my health holds out until then.

March 04 2014 at 12:12 PM Report abuse rate up rate down Reply