[All information is strictly educational in nature and is not tax or financial advice. If you haven’t yet, please review the website disclosure statement here.]
Early Withdrawals Are Necessary
When I started working in the financial services industry as an advisor, I was aghast at the number of people who would take early withdrawals from their retirement accounts. After all, this was money for retirement, not the present! However, I soon realized my naivety, and I was humbled.
You see, part of my job back then was to help individuals overcome devastating financial events: Unexpected funeral expenses, the economic impacts of losing a loved one, how to cover exorbitant medical bills, and how to prevent destitution for families teetering on the edge of ruin.
On the other end of the spectrum, my job included helping individuals plan for aspirational financial events: Retirement, FIRE, university tuition, and purchasing a home.
While the above situations varied greatly, the exposure led to rapid personal growth and the discovery of ways to help people through various events. As a result, my perceptions of early withdrawals changed dramatically.
To this day, I still emphasize the necessity of skipping frivolous withdrawals, but I no longer preach the industry mantra of “No early withdrawals,” which is tone-deaf at best. It is your money, after all!
So, if you happen to fall into the category of needing to access your retirement accounts early, then you need to know about penalties and how to avoid them!
The Dreaded P-Word: Penalty
Generally, if you access a qualified retirement account before age 59.5, you will pay a 10% penalty plus taxes on the withdrawal. Ick!
Now, the government instituted this penalty to discourage people from accessing their retirement savings early. However, while taxes are guaranteed on pre-tax balances and Roth growth for those under 59.5, penalties are not!
[The following exemptions are strictly educational and not financial or tax advice. If you decide to move forward with any of these approaches, I strongly recommend consulting with an advisor or accountant. If that is not possible, do additional research and consider reading the tax code.]
How to Avoid Penalties: IRA & 401(k) Exemptions
Age 55 & above withdrawal – If you retire or leave a company the year you turn 55 or later, all withdrawals from that company’s retirement plan are penalty-free. However, if you roll the 401(k) plan over, this exception goes away.
Roth contribution withdrawal – If you contribute to a Roth IRA or 401(k), you can withdraw your contribution amount after five years without penalty. All growth must stay in the account, though. Otherwise, it is subject to taxes and penalties!
Roth conversion withdrawal – If you decide to convert pre-tax dollars to Roth, you can withdraw the converted amount after five years from both 401(k) and IRA plans. Importantly, you will owe taxes at the time of the conversion unless the dollars are after tax.
NUA Gains – Net Unrealized Appreciation is a complicated subject, and I encourage you to read more about it if you have a 401(k) with company stock. Essentially, NUA boils down to transferring company stock out of a 401(k) plan and paying (the generally lower) long-term capital gains rates instead of ordinary income tax rates. When NUA transpires, any unrealized gains on company stock positions are not penalized; the basis, however, can be if another exemption does not apply to it.
First-time home buyer withdrawal – In the United States, owning a home has been a standard component of the American Dream. To help facilitate this large purchase, the government allows a one-time withdrawal from your IRA account of up to $10,000 without penalty.
Education withdrawal – If you ever plan to go back to school or you have dependents who have education expenses that you want to cover, you can withdraw an unlimited amount from your IRA to do so without penalty. Importantly, this applies to grade school expenses too.
Childbirth or Adoption – Healthcare in the United States is expensive and having traditional hospital childbirth is costly. As a result, withdraws of up to $5,000 from IRAs and 401(k)s can be made without penalty for new parents who give birth or adopt.
Medical expenses exceeding 10% of AGI – On the subject of healthcare, major accidents and emergencies happen. What matters most is surviving these events. Then, in the aftermath, paying them off becomes top of mind. If you have medical expenses that reach or exceed 10% of your adjusted gross income, you can make a penalty-free withdrawal from your 401(k) or IRA to help cover the costs.
Substantially Equal Periodic Payments (SEPP) – If you are ready to create an income stream from your 401(k) or IRA and you are not 59.5, one option to consider is Substantially Equal Periodic Payments. With SEPPs, you initially determine the payment amount and frequency, and then you are locked into the plan until you are age 59.5 and have had payments occurring for at least five years. If you fail to meet both stipulations, all prior payments since inception become retroactively penalized. As a result, it is essential to plan out your SEPP with a high level of certainty that it won’t need to change. Lastly, creating a SEPP plan from a 401(k) is usually unsuitable, as 401(k) plans often change their rules and providers. When these events occur, your SEPPs can be delayed or canceled, and as a result, you can be left with a retroactive penalty. Thus, if you decide to use a SEPP plan, consider using it in tandem with an IRA.
Disability withdrawals – If you are deemed disabled per the IRS definition, withdraws can be made penalty-free from 401(k) and IRA plans.
QDRO withdrawals – Qualified Domestic Relations Orders (QDROs) are created by the courts during the divorce process to split marital assets. The spouse who receives a QDRO 401(k) can make penalty-free withdrawals from that account at any age. However, future penalty-free withdraws are forfeited if the receiving spouse rolls the QDRO account into their 401(k) or IRA.
IRS levy withdrawal – If you happen to be subject to an IRS levy against your IRA or 401(k) plan, any withdraws made to satisfy it are penalty-free.
Inherited retirement account withdrawals – If you inherit an IRA or 401(k) plan, you can make penalty-free withdraws from that account at any age and time.
Direct rollover withdrawal – Rollovers from one financial institution to another are never penalized or taxed, regardless of whether they are done electronically or by check.
60-day rollover withdrawal – One option during the rollover process is what is known as a 60-day rollover. When performed, you receive a check made out to you rather than to another financial institution. If done from an IRA, taxes are not withheld, and you essentially receive a 60-day loan from yourself. However, if you fail to return the money on the 60th day, you are taxed and penalized for the entire amount. Importantly, if done from a 401(k) plan, a 20% tax withholding is mandatory, which is not refunded until you file your taxes the following year. If you fail to come up with the 20% remitted on the 60th day, that amount is taxed and penalized. Talk about frustrating!
Loans – Loans from 401(k) plans are never penalized or taxed if repaid in full.
Addendum One: Any mention of 401(k) and IRA above refers to both traditional and Roth plans.
Addendum Two: Unless a specific amount was mentioned, withdraws could be made up to the account’s total value in all scenarios above. Notably, 401(k) withdrawals can be penalty-free but unallowed due to plan rules. Always check with the 401(k) plan sponsor that the withdrawal you are trying to make is available.
Addendum Three: If a penalty exemption is only available in an IRA or 401(k) plan, you can initiate a rollover from the non-penalty exempt retirement account to achieve the withdrawal. For example, IRA into 401(k) or 401(k) into an IRA. This assumes the 401(k) plan rules allow for such a rollover to occur.
So, now you know of many ways to avoid penalties when making an early withdrawal from your retirement accounts. Use these strategies wisely and only when necessary, as your future self with thank you!
Have you ever used one of these strategies before, or do you plan to in the future? If so, what was your experience in doing so, or why do you plan to use one? Let me know in the comments below, and as always, have a great day!
Mile High Finance Guy
finance demystified, one mountain at a time