Cashing Out Your IRA, 401(k) or 529 Plan

Life doesn’t always go as planned. Money you earmark for retirement may be needed for an emergency expense you never planned for. A child for whom you created an education fund may choose to forgo additional schooling after high school. In both cases, you’ve saved money in special accounts with special rules. What are the consequences when the money in those plans ends up being used for other purposes?

Qualified Retirement and College Savings Plans

The main types of qualified tax-deferred retirement plans used today are traditional IRAs and 401(k)s. Briefly, these plans allow you to save before-tax money in a special account. You save for retirement while lowering your current income tax bill because you expect to be in a lower tax bracket in your future retirement years.

The main type of qualified college savings plan is the 529 plan. This plan lets you save after-tax money in a special account. You save for your child’s education in an account that will allow the gains made in the account to go untaxed if they are used for qualified education expenses. The term “qualified” means "subject to restrictions."

Why These Account Types Are Available

The U.S. government wants to encourage citizens to save for retirement and for advanced education, and one of the best incentives for saving is a tax break. These plans work differently in how the investor ultimately gets the tax break. In a traditional IRA or 401(k), the tax break comes at the beginning on the contributions the saver makes that year. For example, assume you contribute $5,000 to a traditional IRA or 401(k) in 2017, and you make $50,000 in wages and other income that year. When you do your taxes prior to the April 15, 2018 deadline, you will only be taxed on $45,000 of income because you deferred $5,000 that year into your qualified retirement account. Roth IRAs and Roth 401(k)s have a different tax treatment. (For related reading, see: Roth vs. Traditional IRA: Which Is Right for You?)

The 529 plan offers a different kind of tax break. In this account, the money that is contributed to the plan in a particular year is before-tax money that does not reduce your taxable income. In other words, if you contribute $5,000 to your child’s 529 plan in 2017 and you make $50,000 in wages and other income that year, your taxable income for 2017 is still $50,000. When you do your taxes in the early part of 2018, you will still be taxed on $50,000 of income because the $5,000 did not reduce your taxes in 2017. For a 529 plan, the tax break comes years later when your child heads to college. Assume that over 12 years of his or her growing up, you contributed $30,000 to your child’s 529 plan. The $30,000 you invested earned $5,000 in capital gains. When you start to take the money out of the 529 plan to pay for qualified college costs, that $5,000 of gains comes out without incurring tax.

Differences in Withdrawing Money from IRA, 401(k) and 529 Plan

If you need to take money out of your traditional IRA or 401(k), which is also called taking a distribution, you will need to pay taxes on that money. If you are younger than age 59.5, you’ll also pay a 10% penalty. So for example, if you are 40 years old an