401k and IRA early withdrawal penalty and exceptions

If you’re hesitant on contributing too much to retirement accounts because you’re worried about needing money for other big expenses like buying a home or covering a child’s college tuition, then you’re not alone. Choosing how to allocate your savings across different investment accounts can be difficult, and there’s not necessarily a “right” answer.

However, retirement accounts aren’t necessarily as restrictive as you might believe. Sure, the money that you set aside there should be intended for retirement. But, there is some flexibility to get at those funds if it turns out you need them sooner. And, this flexibility might be just what you needed to feel comfortable saving more in the first place.

So, let’s review the rules on when you can withdraw retirement funds.

Quick Primer on Retirement Accounts

Remember, there are four primary retirement vehicles for employees (not including additional options for small business owners and nonprofit employees). The most common is the 401(k) and the Individual Retirement Account (IRA). Both of these have a pre-tax “Traditional” and after-tax “Roth” variation. If you are unfamiliar with the differences, start with this intro blog on retirement savings.

The remainder of this article will thus focus on withdrawals from four types of retirement accounts:

  • Traditional 401k: Employer plan with contributions made pre-tax and withdrawals taxed
  • Roth 401k: Employer plan with contributions made after-tax and withdrawals tax-free
  • Traditional IRA: Individual plan with contributions made pre-tax and withdrawals taxed
  • Roth IRA: Individual plan with contributions made after-tax and withdrawals tax-free

Withdrawing Funds in “Retirement”

The default assumption of these accounts is that funds won’t be withdrawn until you’re in retirement. And when you take what are referred to as “qualified distributions”, then there are no penalties when funds are distributed to you.

Of course, being ‘retired’ isn’t what actually qualifies the distributions. The IRS has set age limits at which time you can start pulling funds from your accounts without penalties.

That age is currently set at 59 ½ years old.

For the “traditional” 401k and IRA, the age limit is the one and only rule that determines whether you can start withdrawing funds.

For the “Roth” 401k and IRA, there’s a second rule that you must be aware of: the five year rule. The five year rule on the one hand gives you more flexibility but is also more restrictive as it has two implications:

  1. The bad news: Even if you are over 59 ½, if you have made contributions to your Roth account within the past five years, the earnings on those contributions cannot be withdrawn yet without penalty.
  2. The good news: If you are under 59 ½, then at anytime you can withdraw up to your original contribution tax free if the contributions were made more than five years ago. For a 401(k) though, this can be difficult in practice to accomplish since the taxable portion of any withdrawal is calculated differently.

Penalties for Early Withdrawals

The default penalty for any withdrawal deemed to be an “early distribution” is 10% of the total withdrawal. The 10% penalty applies to all four of these retirement account types.

It can be even worse if you take money out early of a Traditional IRA within two years of the original contribution. In that case, the penalty increases another 15% for a total penalty of 25%.

But there are exceptions that can allow you to withdraw funds early without penalty. They vary by retirement account vehicle so let’s review these exception rules next.

Exceptions from the Penalties for Qualified Expenses

Remember, for the Traditional IRA and 401(k) unlike the Roth IRA and 401(k), you will always have to pay income taxes on any withdrawn funds. You might be able to avoid the additional 10% penalty if the withdrawal qualifies under one of the below exceptions.

Traditional and Roth 401(k)

The list of exceptions for pulling funds early from your 401(k) include:

  • Medical expenses that exceed 10% of your AGI (or exceed 7.5% of AGI if over 65)
  • You become permanently disabled
  • The IRS issues a levy against you for underpaid tax debts
  • Your impacted by a natural disaster for which IRS relief has been granted
  • You are 55 or older (or 50+ if a public safety or state government employee) and you retired or left your job
  • You will make “substantially equal” withdrawals spread out over your entire lifetime
Traditional and Roth IRAs

The list of exceptions for early IRA withdrawals is a bit broader, including:

  • Covering qualified higher education expenses for you, your spouse, your children, or your grandchildren, including tuition and books/supplies
  • Up to $10,000 for a qualified first home purchase
  • Medical expenses that exceed 10% of your AGI (or exceed 7.5% of AGI if over 65)
  • Medical insurance premium payments during a period of unemployment
  • You become permanently disabled
  • The IRS issues a levy against you for underpaid tax debts
  • You will make “substantially equal” withdrawals spread out over your entire lifetime

Note that it might be beneficial to rollover funds from your 401(k) to an IRA before withdrawing funds to take advantage of the more flexible rules that govern early distributions from IRAs.

Alternatively, You Can Borrow Against Your 401(k)

An alternative option, most typically used when seeking funds for the purchase of a new home, is a loan against a Traditional or Roth 401k account.

Assuming your employer’s plan allows for it, you are allowed to borrow up to 50% of your 401k account balance but only up to a maximum of $50,000. This strategy could be combined with a distribution under the hardship rules or employed on a standalone basis.

You will have to pay back the loan in equal installments within 5 years, so this is not a long-term loan like a 30-year mortgage. The interest rate, which will be set by your 401k plan sponsor, is typically low (relative to other lending alternatives) and is paid back to your 401k account anyway. The downside is that the amount you borrowed will not be invested as long as the loan is outstanding, meaning your 401k will instead just be earning the loan interest rather than the market rate of return.

Key Takeaways

Pulling money out of a retirement account early should almost always be a last resort. The penalties (and tax for the Traditional IRA and 401k) make it less than ideal.

But for some major expenses like buying a first home or returning to graduate school, it might be worth dipping into funds. And knowing you have this flexibility if necessary might make it easier for you to build up a bigger retirement savings pool in the first place!

Still confused? It’s a complex set of rules on early withdrawals so leave a comment below with your question and we’ll reply ASAP!

 

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