How To Get Around the 401(k) Withdrawal Penalty

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Saving for retirement in an employer-sponsored plan like a 401(k) is a smart move. The money is deducted from your paycheck before you even see it, and sometimes your employer will match some or all of your contribution. Save as much as you can in your 401(k) and you could be headed for a nice, comfy retirement.

See: 3 Ways To Recession-Proof Your Retirement

But there is one drawback. If you have a financial emergency and you need to withdraw some or all of that money, you’ll pay income taxes on it, plus an additional 10% penalty if you are under age 59 ½. These withdrawals before age 59 ½ are referred to as premature distributions.

There are, however, some exceptions to the 10% penalty rule. Here’s what you need to know.

If You Are Still Employed

If you are still working for the company that has your qualified plan, your options are pretty limited. There are only a few ways to avoid the 10% penalty for withdrawals taken if you’re 59 ½ or younger.

Medical Expenses

If you have unreimbursed medical expenses that are greater than 10% of your adjusted gross income and you need to take a withdrawal from your 401(k) to pay for them, you will not be assessed the 10% penalty.

Permanent Disability

If you become permanently disabled, you can withdraw funds from your 401(k) without paying the 10% penalty, regardless of your age. (It’s also true that a 10% penalty will not be assessed on your 401(k) assets if you die — in other words, your heirs won’t have to pay it.)

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If the assets in your 401(k) are subject to a qualified domestic relations order and need to be divided due to a divorce, the funds can be moved into an account for your former spouse. Note that the funds will not be withdrawn; they will be transferred into another account, which will have the same restrictions relative to distributions.

If You’re No Longer Working

If you are no longer working at the company where your 401(k) is — you’ve “separated from service,” in IRS parlance — you have a few more options.

IRS Rule 72(t)

There is a little-known IRS rule that allows for early distribution of some qualified accounts before age 59 ½ without penalty, with very specific stipulations. This is known as rule 72(t).

To qualify for rule 72(t), you must:

  • Be separated from service if your money is in an employer-sponsored plan (not an IRA)
  • Take a series of substantially equal periodic payments
  • Take those payments over your life expectancy

Here’s an example. Joe is 55 years old and wants to retire. He has $316,000 in his employer’s 401(k) plan. According to the IRS’ table on single life expectancy, his life expectancy is 31.6 years. He can take $10,000 from his account each year for the next 31.6 years without paying the 10% penalty.

Joe has to continue taking these payments even after he turns 59 ½ and would otherwise not be subject to the penalty. He cannot change the amount of the payments, and he cannot add money to his account (even if it’s an IRA). And all of Joe’s distributions are taxed as any qualified plan distributions would be — it’s just the 10% penalty that Joe avoids by using rule 72(t).

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If You Have an IRA or Can Roll Over Your 401(k) Into One

There are additional exceptions that apply if you are taking money out of an IRA, including a SEP, SARSEP or SIMPLE IRA. If you have a 401(k) and are leaving or have left the employer, you can roll over your 401(k) into an IRA and then take the money out of the IRA.

If you are able to do this, you can take premature distributions without paying the 10% penalty to pay for:

  • The purchase of your first home (up to $10,000)
  • Qualified higher education expenses
  • Medical premiums you paid while you were unemployed

Be Careful When Taking Premature Distributions

There are several drawbacks to taking money out of your 401(k) before you are retired, regardless of whether you can avoid the 10% penalty or not.

Here’s what you need to know.

Income Taxes

Even if you are able to avoid the 10% penalty on retirement distributions before age 59 ½, those distributions will still be subject to income tax. The amount you withdraw will be added to your earned income, and you will be taxed on the combined amount. If you are still working and have significant income, you could pay a high rate of tax if you take premature withdrawals.

Loss of Tax-Deferred Earnings

Qualified retirement plans were developed to give people a way to save money, and to make money on their savings without having to pay taxes on it until they took it out. By withdrawing your retirement assets early, you miss out on the tax-deferred growth.

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Unvested Employer Matching Funds

If you withdraw your entire 401(k) account, you could be forfeiting some of your employer matching funds. Most employers set a vesting schedule for matching funds, which means that, for example, you get 20% of your matching funds each year. After five years, all matching funds are yours, but if you leave the company prior to that time, you’ll lose out on any unvested funds.

Final Take

Qualified retirement plans are a great way to save money during your working years so that you can enjoy a comfortable retirement. The tax benefits are significant, in that your money grows tax-deferred in “traditional” accounts and you are only taxed when you withdraw the money, presumably when your income is lower, and you are therefore in a lower tax bracket than you were when you were working. In the case of Roth plans, your contributions are made after you pay taxes on them, but at retirement, both contributions and earnings are tax-free.

In exchange for these tax advantages, there are restrictions on when you can take withdrawals without being penalized. Think long and hard about other possible options before you consider a premature distribution from your 401(k) account.

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