How To Avoid Taking Early Withdrawals on Your 401(k)s and IRA

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With life being so unpredictable, you never know when an event will prompt the need for an early withdrawal of funds from an account earmarked for retirement. However, unless circumstances make it absolutely unavoidable, there are ways to access your 401(k) or individual retirement account without triggering the standard 10% penalty.

The 10% penalty isn’t the only consequence of an early IRA or 401(k) withdrawal. Early withdrawals from retirement plans, even if exempt from penalty, are treated as ordinary income and could be subject to 20% federal income-tax withholding, according to Forbes. Additionally, taking out funds from your accounts will leave you less money for retirement and possibly cause you to lose out on a pile of money in investment returns.

Plans vary and exemptions are specific and may not apply to all types of retirement accounts, so it is important to follow your retirement plan’s guidelines and IRS rules to ensure the funds you want to withdraw aren’t penalized.

Here are four ways to withdraw funds from your 401(k) or IRA without penalty.

1. Special Circumstances or Hardship Withdrawals

The IRS lists specific penalty-free instances that allow an IRA or 401(k) holder to withdraw funds from their account. Generally speaking, an IRA hardship withdrawal would be to cover expenses related to: higher education expenses, a first-time home purchase (cannot exceed $10,000), health insurance premium payments while unemployed, unreimbursed medical expenses (above 10% of adjusted gross income) and certain expenses if you’re a qualified military reservist called to active duty.

Are You Retirement Ready?

Early 401(k) withdrawals also have penalty exemptions, although they differ somewhat from IRA exemptions. For example, you can take a penalty-free withdrawal in the event of disability or qualified unreimbursed medical expenses, or if you’re a qualified reservist called to active duty. But you can’t take one for a first-time home purchase or for higher-education expenses.

Details on exemptions, qualified plans and relevant code sections can be found on the IRS Exemptions to Tax on Early Distributions page, located here.

2. The Rule of 55

An individual may get early withdrawal penalties waived if they fall under the Rule of 55 exemption. If you are between the pre-retirement ages of 55 and 59 ½ and leave your job by any means — quitting or retiring early, getting fired or laid off — you may be able to withdraw savings from your 401(k) and not have to pay penalties.

This rule only applies to a 401(k) account an individual has with their current employer. It does not extend to IRAs.

3. Substantially Equal Periodic Payments

The IRS allows penalty-free withdrawals from 401(k) accounts and IRAs if you take substantially equal periodic payments for at least five full years or until age 59 ½. Payment amounts are based on your account balance and an IRS-approved method of calculating distributions.

4. 401(k) Loans

Some 401(k) plans (but not IRAs) allow participants to take out a loan against their account balance. If you are eligible through your plan, you can take up to the lesser of 50% of your account balance or $50,000.

Are You Retirement Ready?

However, as Forbes points out, there is one big risk in taking out a 401(k) loan from your retirement savings: Because 401(k)s are employer-sponsored personal pension funds, if you lose or leave your job after taking out a loan, you may be forced to repay the entire loan amount in a short period of time. If you cannot afford to do this, you may be subject to the same early withdrawal penalties you were trying to avoid in the first place, plus income tax on the borrowed amount.

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