With many things in life, there are rules and regulations to follow, and the same is true for retirement accounts. Individual retirement accounts (IRAs), 401(k) plans, and self-employed plans all have specific structures, and if you aren’t careful with your investments and management of the account, you may face retirement plan penalties, which include fees, increased taxes, and more.
To avoid potential penalties, it’s important to understand the structure of the retirement plans you participate in, and work with a financial advisor if you need help navigating the rules and regulations.
Read below to learn about common retirement plan penalties and how to avoid them.
Early Withdrawals
With most retirement plans, there is an age limit on when you can start withdrawing funds for retirement, and anything withdrawn before then can result in a hefty penalty. With a 401(k) plan, for example, the penalty is 10% early withdrawal tax on funds removed from the account before the participant reaches age 59½. The penalty is paired with standard federal income tax participants must pay on the withdrawal, which is seen as income. Depending on how much you’re taking out of the account, these taxes and fees may not be worth an early withdrawal.
Of course, as with many rules, there are exceptions. You may be able to avoid a penalty fee if you qualify for an exemption, summarized by The Balance below.
- You have a disability
- You’re paying levies to the IRS
- You have unreimbursed medical expenses totaling 7.5% or more of your adjusted gross income
- You leave an employer during or after the year you reach age 55, and 50 if you’re a state employee or first responder
Regardless of the exception, it’s important to read through the IRS requirements to ensure you qualify before making withdrawals. You’ve spent your life building a retirement nest egg and should plan to use it for your golden years unless you have no other choices financially. Early withdrawal fees can add up quickly when paired with income taxes and may put you in a worse position in the future.
Excess Contributions
The IRS determines contribution limits for retirement plans on an annual basis. These limits are determined annually to account for things like inflation, cost of living, and other factors. View the current IRS contribution limits.
If a participant exceeds the contribution limit, known as an excess deferral, you will be required to report the excess as taxable income in the current tax year, but will also owe income tax on the funds when you withdraw them in retirement, resulting in a double tax on the contribution.
If you find your account is in excess, you can avoid the double tax by removing the excess amount and profits from the investment from your retirement account before filing your taxes, which is known as a corrective distribution. This allows you to correct the mistake and save money on penalties in your current tax year and in retirement.
Mutual Funds
Known for its convenient approach to investing, mutual funds provide investors with the opportunity to purchase a variety of investments in one transaction. The pooled funds are then managed by a professional who manages the investments on behalf of the participant.
Because the account is managed by participant, however, there are management fees incurred. These fees can significantly reduce your returns over the decades and impact your retirement plan and readiness.
Before investing in a mutual fund, make sure you understand the fee structure and ask questions along the way. Knowing what you’ll be charged month-over-month or year-over-year can help you make informed decisions on if a mutual fund is the right retirement approach for you.
To forecast the impact of fees on your retirement account, visit the Slavic401k calculator library.
Whether retirement is decades away or getting close, it’s important to understand the fees and penalties you may face with various types of investments and plans. As you’ve learned, withdrawing too early, or contributing too much, can impact your taxable income and result in hundreds – or thousands – of dollars in fees.
To avoid this, you can meet with a wealth management professional, who can help you refine your retirement goals and strategy, setting you up for success for years to come. Connect with a Slavic401k professional here.
Not sure where to start? A financial advisor may be able to get you on the right path. Learn about the different types of advisors and their services here.
Related: 4 Retirement Mistakes to Avoid
