If you’re forced to tap retirement funds early, you’d better know the rules.
401ks, IRAs and other pretax retirement savings accounts are now the most common way to save for retirement, and millions of Americans pour money into them every year. Unfortunately, millions more take early withdrawals from these accounts due to hardship, loss of a job or other money woes.
If you take a distribution from an IRA or a 401k before the age of 59 ½, you’re assessed a 10% penalty tax in addition to any other taxes you owe. That adds up. According to a very revealing IRS tally of tax returns, in 2011 Americans paid over $5 Billion in early withdrawal penalties alone!
If you desperately need the money, the 10% early withdrawal penalty is probably not much of a barrier. However, before you pay up you should know some useful exceptions and loopholes in the laws that govern retirement accounts. These exceptions may make it possible for you to tap your retirement savings in a time of need without having to pay the IRS for the privilege. They require some planning and care to implement, so it’s best to know about them before you need them.
Retirement funds locked away?
I first had the opportunity to invest in a 401k account when I was 22 years old, just after college graduation. But the realization that the money was essentially gone, and would be locked away for a period longer than my entire lifetime at that point was worrisome. Age 59 ½? I felt like I was saving money for an entirely different person!
The easy way to solve this problem was to contribute to a Roth IRA. Because my contributions to the Roth were after-tax, I knew I could withdraw them immediately with no penalties. Any earnings on the contributions would still be restricted, but knowing that I could access some of my retirement money was a comfort.
Unfortunately, most of my money was going into a 401k, and there was no Roth option. In an effort to feel more comfortable while salting away my earnings, I put together a list of situations wherein I could access my money if I really needed it. I’ve since updated the list, and am sharing it below. I’ll do you a favor and skip over the items that deal with death or complete disablement. In that case, a penalty tax is not likely to be top of your concerns.
Keep in mind that although these exceptions enable you to avoid the 10% penalty, you will owe income tax on any IRA distributions. Also remember that these are broad outlines. Anyone wanting to tap retirement funds early should talk to their Personal Capital financial advisor.
REASONS FOR PENALTY-FREE RETIREMENT FUND WITHDRAWALS
You are allowed to take an IRA distribution for qualified higher education expenses, such as tuition, books, fees and supplies. This distribution is taxed at your ordinary income rate, but there won’t be a penalty. For instance, if you want to go back to graduate school and you need the money, you can decide to tap your retirement fund for tuition. The rule also allows you to apply this exception to your spouse, children or their descendants.
First-time home purchase:
You can take up to $10,000 out of your IRA penalty-free for a first-time home purchase. If you are married, your spouse can do the same. And “first-time home” is defined pretty loosely. For the purposes of the IRS, it is your first-time home if you have not had an ownership interest in a home for the past 2 years. Just like the education exclusion, you can also tap this option for the benefit of your family. Your children, parents or ancestors may receive the same $10,000 for their purchases, even if you’ve used this benefit for yourself previously or already own a home.
Medical expenses or insurance:
If you incur unreimbursed medical expenses that are greater than 10% of your adjusted gross income in that year, you are able to pay for them out of an IRA without incurring a penalty.
Create an Annuity:
Unbeknownst to me until right before this article, you can begin taking distributions from your IRA without penalty, anytime you want, by taking a 72t early distribution. It is named for the tax code which describes it, and it allows you to take a “Series of Substantially Equal Periodic Payments”, based on a calculation involving your current age and the size of your IRA. More details here.
The catch is that once you start, you have to continue taking the periodic payments for five years, or until you reach age 59 ½, whichever is longer. Also, you will not be allowed to take more or less than the calculated distribution, even if you no longer need the money. So be careful with this one!
What if you only need the money short term?
So although there are other qualifying exceptions to withdraw IRA assets penalty-free, those are the major ones. But suppose you’re not interested in paying any taxes at all. You can still use your 401k to borrow money from yourself while paying interest to yourself, without it being a taxable event or showing up on your credit report. Here’s how:
You are allowed by the IRS to borrow against your 401k, provided your employer permits it. Your employer will administer and set the terms of the loan. The maximum loan amount permitted by the IRS is $50,000 or half of the 401k, whichever is less. During the loan, you pay principle and interest to yourself at a couple points above the prime rate, which comes out of your paycheck on an after-tax basis. Generally, the maximum term is 5 years, but if you use the loan as a down-payment on a principal residence, it can be as long as 15 years.
The benefits of such a loan are obvious. You do not need a credit check, nothing appears on your credit report, and interest is paid to you instead of a bank or credit card company. The interest rates are usually lower than what you could receive elsewhere, and the paperwork is not complex.
Now the downsides: If you leave your leave your employer (or are fired), your loan is generally due right away, usually within 60-90 days. If you can’t pay it back, you will be assessed a penalty by the IRS. Also, taking a 401k loan depletes your retirement principal and will cost you any compounding that your borrowed funds would have received.
IRA Rollover Bridge loan:
There is one final way to “borrow” from your 401k or IRA on a short-term basis, and that is to roll it over into a different IRA. You are allowed to do this once in a 12 month period. When you roll an account over, the money is not due into the new retirement account for 60 days. During that period, you can do whatever you want with the cash. However, if it’s not safely deposited in an IRA when time is up, the IRS will consider it an early distribution and you will be subject to penalties on the full amount. This is a risky game and is not recommended, but if you want an interest-free bridge loan and are sure you can pay it back, it’s an option.
DO YOUR BEST TO NEVER WITHDRAW
Despite the reasons allowing you to withdraw penalty-free, do your best never to touch your retirement funds until you’re retired. The ability to compound your earnings pre-tax is a major contributor to having a financially rock solid retirement. However, it remains your money even before you retire, and knowing the rules of the game can allow you to make informed decisions and avoid having to pay needless fees and taxes. Don’t contribute to the billions of dollars going to the IRS in penalties every year, if you can possibly avoid it. They receive enough already.
Readers, have you ever tapped your retirement funds early for an emergency or one of the reasons above?
Photo: Golf course in Hawaii with Hawaiian islands as sand traps.