You work, you save, you retire – it’s the American way, right?  But what happens when you have done a good job saving and get to be one of the lucky ones to retire early – are you still subject to the IRS rules of being age 59 1/2  before you can touch your money? (Side rant: what the heck is up with the IRS and these 1/2 ages anyway? This concludes my rant.)  If you are stressed about having to pay the 10% early withdraw penalty, don’t freak out just yet.   The IRS – believe it or not – does allow methods to withdraw funds from your 401k without penalty.  Just make sure you follow the rules before you claim your prize.

A few notes before hand…

1. You always have the option to take a 401k loan (if your plan allows it).  Does that mean you should take it?  I’m hoping that you have ample emergency funds that you can tap first. Stated another way and more blunt: You BETTER have enough emergency funds. Got it? If not, make sure you know the 401k hardship rules.
2. Before you make any withdraws at of your 401k, do more than just read this post.  Consult your financial advisor and/or tax professional to make sure you have your bases covered.

Another thing, the methods shared below allow you avoid the 10% penalty, but they do not….I REPEAT…..do not prevent you from having to pay the tax.   Now that we have that taken care of, let’s see how you can withdraw funds from your 401k penalty free….

1. A Visit From The Grim Reaper

Okay, I’m sure that death is probably not the option that you wanted to hear.  I guess technically you don’t benefit.  Rest assure that your family will benefit in that they can use your retirement funds to cover burial expenses and supplement other income needs now that you’re not around.   Just make sure to update your beneficiaries << you have been warned.

2. Qualifying Disability

If you have been deemed to be disabled either buy an insurance company or Social Security, then you are entitled to withdraw from your 401k penalty free.  You’ll have to provide a disability letter to your 401k custodian to verify your status and avoid the penalty.

3. Medical Bills

A visit to the emergency room can add up really quick nowadays.  Our middle son banged his head on our bathroom doorway and we found that out really quick.  CHA-CHING!  If you don’t pay them, next thing you know you have debt collectors hounding you.   To avoid the penalty a few things have to occur:

1. Withdraw Same Year. You have to take the money out in the same year you incurred the medical bills.
2. 7.5% Rule. Take 7.5% of your AGI (Adjusted Gross Income) and that’s the to the extent that the unreimbursed medical bills that you’ll be allowed to claim penalty free from your 401k.

On a side note, it is not required to itemize your deductions to qualify for this.  If you don’t know what that means, then you better pay somebody to do your taxes for you.

And if you think that I had to tap my 401k to pay for my son’s emergency room visit, get your head out of the gutter.

4. Disaster Relief

With all the storms and flooding that have hit the U.S. recently, it’s a comfort knowing that if your area is deemed for disaster relief you can tap your 401k for necessary expenditures.

5. 55 and Separated From Service

According to the IRS, those that retire early or force out may have access to their 401k early.   This is their wording:

“Made to a participant after separation from service if the separation occurred during or after the calendar year in which the participant reached age 55″

You can take a distribution from a qualified defined contribution plan, i.e. 401(k), and avoid the 10% penalty. A couple key things to note on doing this is that it must be from the 401(k), 457 or 403(b), to avoid the 10% penalty. This actually happened to my father in law as his company went through a buyout and he was offered an early retirement package at the age off 55.  We ended up taking a distribution from his 401k to have some cash on hand and then rolled the rest into his IRA.

Don’t miss this important point: DO NOT roll over to an IRA if you think you may need some money.

If you have already done a 401(k) rollover into a traditional IRA, you have already missed this opportunity. Once you hit the IRA and you take a withdrawal, you are then assessed a 10% penalty.  Rolling to an IRA might make sense later on, but until you know for sure – don’t do it.

6. Stay Equal and Periodic With 72t

Another more complex strategy – that I’m not very fond of – is the little know rule of 72(t).  Why am I not fond of it?  Because 1. it locks you in for long time and 2. it’s too complicated for most.

What is the rule 72(t)?  The rule of 72(t) states that withdrawals from your 401k have to be “substantially equal periodic payments. You must use one of the three methods that the IRS has determined and then take your payment on a set schedule for a specific time period. It is required that you take those payments for either 5 years or when you turn 59 1/2 , whichever comes later.

Example of 72(t)

Let’s say you retire at the age of 53 and you elect to do 72(t) then you must take equal payments for 7 years.  If you happen to need more money during that 7 years stretch, then you’ll have to go back and pay the 10% penalty on everything taken out to that point.   Now do you see why I’m not a big fan?

If you start later on, say 56, then you’ll have to take it for 5 years till the age of 61 even though you’ve already hit 59 1/2.

401k Penalty Free Withdrawals

As you can see, there are ways to tap your 401k penalty free.  Just make sure you follow the rules.

photo credit: elora.daphne

IRA’s (Individual Retirement Accounts) are a vital tool in retirement planning.   Younger investors may prefer the Roth IRA, while baby boomers may choose the traditional IRA.   When you retire, you may want to convert all your retirement assets into a rollover IRA.   So many choices and even more options can leave somebody overwhelmed on what the right IRA to choose when planning for retirement.   If you have an IRA, be sure to avoid these 12 mistakes:

1. Not taking advantage of the stretch distribution option or not establishing it properly.

The “stretch IRA” is a way for each IRA beneficiary to maximize payouts over his or her entire life expectancy. Properly designating beneficiaries and informing them of the IRA owner’s “stretch” intentions are key to making this strategy work.

2. Not naming or updating IRA beneficiaries.

Not listing primary and contingent beneficiaries may result in the distribution of the IRA assets to the IRA owner’s estate, resulting in accelerated distribution and taxation. Not keeping beneficiary designations current and coordinating them with other estate planning documents can also lead to conflicts and unintended results.

3. Making inappropriate spousal rollovers.

Most IRAs list the owner’s spouse as the primary beneficiary. One of the most popular strategies for a spousal beneficiary is simply to roll the inherited IRA into his or her own IRA. But in some cases it can be more tax efficient for a surviving spouse to keep the IRA as an inherited beneficiary IRA or disclaim the assets, thereby allowing them to pass to the contingent beneficiary.

4. Not taking advantage of “IRD” if you are a beneficiary.

Upon the death of the IRA owner, his or her IRA is included in the estate, creating an estate tax liability (if applicable) as well as an income tax liability for beneficiaries. Many IRA beneficiaries do not realize that IRAs are considered “Income in Respect of a Decedent” (IRD), according to Section 691(c) of the IRS Code. The IRD designation allows beneficiaries to take a federal income tax deduction for any estate taxes paid on the IRA’s assets, thus limiting double taxation of the IRA assets.

5. Rolling low-cost-basis company stock into an IRA.

Distributions from a qualified plan such as a 401(k) are generally taxed as ordinary income; federal income tax rates range from 10% to 35% (as of 2009). If company stock is rolled into an IRA, future distributions are taxed as ordinary income. If, instead, the company stock is taken as a lump-sum distribution from the qualified plan, only the cost basis of the stock is taxed as ordinary income. This is called Net Unrealized Appreciation. (Note: The distribution must be taken as stock, not cash.) Unrealized capital appreciation (the difference between the cost basis and current fair market value) is not taxed until the stock is sold, upon which it would be taxed as long-term capital gains, which are taxed at a lower rate than ordinary income (at 2009 tax rates). Be sure to talk with your tax advisor.

6. Not taking advantage of a Roth IRA.

A Roth IRA is a potentially valuable retirement resource. Not only are qualified withdrawals tax free, but Roth IRA distributions do not impact the taxability of Social Security, and Roth accounts pass to beneficiaries tax free as long as the account passes the five year rule for qualified distributions. There are income limits that affect eligibility for a Roth IRA, so be sure to talk this option over with your financial advisor.

7. Not taking advantage of increased contribution limits.

The contribution limits for 2009 are $5,000.  IRA owners age 50 or older can make an additional $1,000 “catch-up” contribution in 2009. Roth IRA limits and traditional IRA limits are the same.

8. Assuming that a nonworking spouse cannot contribute.

The truth is that separate “spousal” IRAs may be established for spouses with little or no income up to the same limits as the working spouse.

9. Missing important dates.

Estate taxes, if applicable, are due nine months after the IRA owner’s death. The same deadline applies to beneficiaries who wish to disclaim IRA assets. By September 30 of the year following the year of the owner’s death, the beneficiary whose life expectancy will control the payout period must be identified. Generally, IRA beneficiaries who want to receive distributions over a life expectancy must begin taking required distributions by December 31 of that same year.

10. Taking the wrong required minimum distribution (RMD).

IRA owners in their seventies are required to take the RMD out of their accounts each year, based on the value of all their non-Roth IRAs. Those who do not take enough out each year may be subject to a federal income tax penalty of 50% of the amount that should have been taken as an RMD but was not. Consolidating retirement assets may make it easier to manage these distributions. Current law allows a one-time suspension of the requirement to take an RMD for 2009. RMDs must resume in 2010.

11. Placing the title of an IRA in trust.

Making a trust the actual owner of an IRA causes immediate taxation — including the 10% penalty tax if the IRA holder is under age 591⁄2.

12. Paying unnecessary penalties on early (pre-age 591⁄2) IRA distributions.

As long as withdrawals are made in accordance with the requirements of IRS Code Section 72(t), there is no need to pay penalties on distributions from IRAs before the owner is age 591⁄2. Section 72(t) allows for three calculation methods to determine substantially equal periodic payments based on the owner’s life expectancy. Payments must continue for 5 years or until age 591⁄2, whichever is the longer period of time.

photo by Charles NJC

*Restrictions, penalties and taxes may apply.  Unless certain criteria are met, Roth IRA owners must be 59 1/2 or older and have held the IRA for 5 years before tax-free withdrawals are permitted.

72t Alternatives

Some of you may be considering initiating 72(t) distributions. 72(t) distributions takes careful planning and consideration.  Before you lock in those payments, there are some alternatives that you may want to explore:

Leave Your Job Early

If you leave your job January 1st of the year you turn 55 (50 for certain government agencies),   you   are allowed to pull out lump sum distributions out of your company retirement plan penalty free.   Notice I said retirement plan and not IRA.  Once you rollover into an IRA, you lose out on that opportunity.  Consider leaving a portion of money in the retirement plan as a precautionary.  Or you can just take a lump sum distribution out of the plan and pay the tax and park it in a high interest savings  account for emergency purposes.  Do remember that you will pay ordinary income tax on that distribution.

Dont Foget About After Tax Contributions

You can also tap into after tax contributions to your 401k, non-deductible IRA contributions, or after tax contributions to your Roth IRA.  Consider these penalty free options first prior to locking in your payments.

Net Unrealized Appreciation

Even a bigger secret than 72(t) is NUA.  What is Noo-uhh you ask? Well, it is the acronym for Net Unrealized Appreciation.  Get it yet?  Didn’t think so.  NUA pertains to employer stock that you have in your retirement plan that may have an extremely low cost basis.  You may be one of the lucky ones that started working for the company prior to them going public and you’ve seen your company stock double and split more times that you can count.  If you utilize the NUA on your stock you will just be penalized on the basis, not the total value of the stock.

For example, if you have company stock that is valued at $100,000 but your basis in the stock is only $20,000, you would be only penalized on the $20,000 if you took it early, if you are under 59 ½ .  The remaining gain ($80,000) would be taxed as a long term capital gain when you decided to liquidate it, not ordinary income.  That could be the difference between 15% and 35% in taxes, depending on your tax bracket.

Warning! Once you roll over your employer stock into the IRA, you forfeit your NUA.

These are just a few of the alternatives that one can explore before committing to the 72(t) distribution rule.

Securities offered through LPL Financial, Member FINRA/SIPC