There are many circumstances where a person may need access to Traditional IRAs, 401(k)s, or other retirement funds, before they are of retirement age. Typically, the IRS will impose a 10% penalty on withdrawals that you take prior to the age of 59 1/2. But there are several instances where accessing these funds is possible without paying the penalty.
First, you need to know that you will pay income tax on retirement withdrawals or distributions that are made from a Traditional IRA or 401(k). The reason for this is because when you make a contribution to a Traditional IRA or 401(k), you receive a tax deduction from the IRS. Then, when you take withdrawals or income from those accounts, it is treated as taxable income. There is no way around this, it’s simply how it works. Withdrawals or distributions from a Roth IRA may also be subject to income taxes if certain requirements or exceptions are not met.
While retirement withdrawals or distributions from Traditional IRAs, 401(k)s and most other retirement plans are always regarded as taxable income, avoiding the 10% penalty for early retirement withdrawals is possible under the following circumstances:
1. When you are divorcing and need a withdrawal from a spouse’s 401(k). If you are receiving a rollover of 401(k) funds from your spouse as a result of divorce, you may request a one-time withdrawal or distribution, in any amount, that is free from the 10% penalty. You must initiate the withdrawal request prior to the rollover of these funds into an IRA. You may not use this exemption for withdrawals from an IRA. In other words, know how much you need before you rollover or transfer these funds. Once they reach the IRA, any withdrawals or distributions will be assessed the 10% penalty.
2. If you take substantially equal income payments. Some people under the age of 59 1/2 need ongoing income from retirement assets. In the case of an early retirement, divorce, or during a period of hardship, it may be possible to avoid paying the 10% penalty by taking substantially equal payments over a period of years. IRC 72(t)(2) lays out the guidelines for how to avoid the penalty and one of them is that the the income period must be the greater of 5 years or age 59 1/2. As an example, a 53 year old woman would need to take these equal income payments for 6 1/2 years, and a 57 year old woman would need to take them until age 62. There are three IRS-approved methods for determining these payments – you cannot come up with your own plan. And you need to stick to it. Any deviation could trigger a 10% penalty on withdrawals or distributions.
3. When you utilize loan provisions in a 401(k). In this situation, you can literally borrow up to $50,000, in most cases, from your 401(k) plan and pay yourself back with interest. The payback terms are contractual, and you need to make a commitment to a repayment plan over months or years. If you do not follow the repayment plan, your loan will be considered an early retirement distribution, and the borrowed funds will be assessed a 10% penalty. When managed properly, this is a helpful option. But it can be potentially costly if you stray from the plan.
4. For Education. Yes, you can access your retirement funds without paying a 10% penalty for funds you are specifically using for education expenses. There are some limitations and important considerations, so tread carefully here.
5. For buying a home. You have one chance to utilize your $10,000 exemption from the 10% penalty. It is not available every time you buy a home. Use it wisely.
Any time you’re faced with tax considerations, it is always wise to consult with a tax advisor or CPA. While these situations offer relief from the penalty, they can have an impact on your ability to grow and benefit from your retirement funds in the future. For this reason, retirement plan withdrawals should be your last resort when there is a financial need.