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?
Ways to claim your 401k early and penalty-free
(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 Beforehand
- You always have the option to take a 401(k) 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 bluntly: You Better have enough emergency funds. Got it? If not, make sure you know the 401(k) hardship withdrawal rules.
- Before you make any withdrawals from your 401(k), 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 to 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 401(k) 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 assured 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
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 quickly nowadays. Our middle son banged his head on our bathroom doorway and we found that out really quick.
If you don’t pay them, the next thing you know you have debt collectors hounding you. To avoid the penalty a few things have to occur:
- Withdraw Same Year. You have to take the money out in the same year you incurred the medical bills.
- 7.5% Rule. Take 7.5% of your AGI (Adjusted Gross Income) and that’s to the extent that the unreimbursed medical bills that you’ll be allowed to claim penalty-free from your 401(k).
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 401(k) for necessary expenditures.
5. 55 and Separated From Service
According to the IRS, those who retire early or are forced out may have access to their 401(k) 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 of key things to note in 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 of 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 72(t)
Another more complex strategy – that I’m not very fond of – is the little-known rule of 72(t). Why am I not fond of it? Because 1. it locks you in for a 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-year 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 401(k) penalty-free. Just make sure you follow the rules.