What Happens If I Cash Out My 403b Early?

A 403(b) plan is a retirement savings vehicle available to employees of public schools, certain tax-exempt organizations, and ministers. Contributions are typically made through payroll deductions and often grow tax-deferred, meaning taxes are not paid until funds are withdrawn in retirement.

The primary purpose of a 403(b) is to encourage long-term savings for retirement, similar to a 401(k) plan. While designed for retirement, accessing a 403(b) before age 59½ can lead to significant financial consequences. These implications involve both income tax obligations and potential additional penalties, which can reduce the overall value of the withdrawal.

Income Tax on Early Withdrawals

When funds are withdrawn early from a traditional 403(b) plan, the entire taxable portion of the distribution is subject to ordinary income tax. This amount is added to an individual’s gross income for the tax year, potentially pushing them into a higher income tax bracket and increasing their tax liability.

Contributions made to a traditional 403(b) are typically pre-tax, reducing taxable income in the year they are contributed. Because these contributions and their earnings have not been previously taxed, they become fully taxable upon withdrawal. For Roth 403(b) accounts, the tax treatment differs.

Contributions to a Roth 403(b) are made with after-tax dollars, so the contributions themselves can be withdrawn tax-free at any time. However, earnings on Roth 403(b) withdrawals are tax-free only if the distribution is “qualified.” A qualified distribution typically requires the account to be held for at least five years and the account holder to be age 59½, disabled, or deceased. If Roth 403(b) earnings are not qualified, they may be subject to ordinary income tax and potentially the early withdrawal penalty.

Understanding Early Withdrawal Penalties

In addition to ordinary income tax, early withdrawals from a 403(b) plan before age 59½ are generally subject to a 10% additional tax. This penalty is imposed by the Internal Revenue Service (IRS) to discourage individuals from using retirement funds for non-retirement purposes. The 10% additional tax applies to the taxable portion of the withdrawal.

For example, if an individual withdraws $10,000 from a traditional 403(b) before age 59½ and no exceptions apply, they would owe $1,000 in early withdrawal penalties, in addition to their regular income tax on the $10,000. This penalty can significantly diminish the amount of money actually received from the withdrawal. The rationale behind this penalty is to preserve the tax-advantaged status of retirement accounts for their intended long-term savings goal.

This penalty applies broadly to most early distributions from 403(b) plans, reinforcing that these accounts are designed for retirement income. It underscores the importance of carefully considering alternatives before taking an early withdrawal, as the financial impact can be substantial.

Situations Where Penalties May Not Apply

While early withdrawals from a 403(b) typically incur a 10% additional tax, certain circumstances allow for penalty-free distributions before age 59½.

One common exception applies if an individual separates from service (leaves their job) in or after the year they turn age 55. This is often referred to as the “Rule of 55” and allows penalty-free access to funds in the 403(b) plan from the employer they just left. For qualified public safety employees, this age threshold is even lower, at age 50.

Another exception is for distributions made due to total and permanent disability, meaning the individual meets the IRS’s definition of being unable to engage in substantial gainful activity due to a severe impairment. Distributions made to a beneficiary after the account holder’s death are also exempt from the 10% early withdrawal penalty.

Qualified medical expenses exceeding 7.5% of an individual’s adjusted gross income (AGI) can also be withdrawn penalty-free. Additionally, distributions made as part of a series of substantially equal periodic payments (SEPP), calculated over the individual’s life expectancy or the joint life expectancies of the individual and their beneficiary, can avoid the penalty. These payments must continue for at least five years or until the individual reaches age 59½, whichever is later. Finally, distributions made to an alternate payee under a Qualified Domestic Relations Order (QDRO), typically as part of a divorce settlement, are also exempt from the early withdrawal penalty.

How Distributions are Processed and Reported

When an early withdrawal is made from a 403(b) plan, federal income tax withholding is generally mandatory. For distributions eligible for rollover but not directly rolled over, a mandatory 20% federal income tax withholding applies. For other non-rollover distributions, a 10% federal withholding may apply, although individuals can sometimes elect a different withholding amount. State tax withholding may also apply, depending on the individual’s state of residence and its specific tax laws.

After an early withdrawal, the plan administrator will issue Form 1099-R, “Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.” This form reports the gross distribution amount in Box 1, the taxable amount in Box 2a, and any federal income tax withheld in Box 4. It also includes a distribution code in Box 7, which indicates the type of distribution and whether an early withdrawal penalty might apply.

The information from Form 1099-R is then used to report the withdrawal on the individual’s annual income tax return, typically Form 1040. The taxable portion of the distribution is reported as ordinary income. If the 10% additional tax on early distributions applies, it is reported on IRS Form 5329, “Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts.” This form calculates the penalty and ensures proper reporting to the IRS.