Accessing retirement accounts before age 59½ can prove costly, usually resulting in a penalty of 10 percent of the amount withdrawn. While many savers do not intend to tap into their IRA or 401(k) before they retire, unforeseen emergencies can leave pre-retirees with few viable choices.
In fact, with so few families maintaining appropriate cash reserves or having access to other forms of credit, retirement savings are often used to fill the role of an emergency fund. In addition to emergencies, some savers would simply like to retire prior to age 59½ and need to have access to their accounts in order to make their early retirement dreams a reality.
The good news is that it is possible to tap retirement accounts in certain circumstances before age 59½ while still avoiding early withdrawal penalties. However, rules will vary depending on whether the account is an IRA or 401(k) and distributions will be subject to ordinary income tax rates (except for Roth and after-tax withdrawals). Also, remember that even if you can avoid the 10 percent penalty, premature distributions can be detrimental to your long-term retirement goal, so be careful.
The first categories which may qualify for early distribution without penalty are referred to as hardship withdrawals. From first-time home purchases and medical expenses to college costs and disability, there are various hardship circumstances that may apply. According to the IRS, “For a distribution from a 401(k) plan to be on account of hardship, it must be made on account of an immediate and heavy financial need of the employee and the amount must be necessary to satisfy the financial need.” In other words, you cannot take a hardship withdrawal to pay for a vacation or to install a swimming pool. The following are cases where withdrawals may be possible.
Unreimbursed medical expenses: Penalty-free IRA and 401(k) withdrawals are allowed for medical expenses. Keep in mind they must be in excess of 10 percent of your adjusted gross income. See IRS publication 590 for more information.
College costs: IRA withdrawals to cover the cost of higher education for you, your spouse or children will not be subject to the 10 percent penalty. While hardship withdrawals are allowed from a 401(k) for tuition expenses, the 10 percent penalty will still apply. You are simply able to get your money out of the plan. Remember that any distributions from your retirement accounts will increase your taxable income and could affect your ability to receive financial aid.
First time home purchase: This is another category where rules vary between an IRA and 401(k). Penalty-free withdrawals of up to $10,000 or $20,000 for a couple are allowed from an IRA account for the purchase of your first home. According to the IRS, you may be considered a first-time home buyer if you or your spouse did not own a home in the past two years. However, first-time home buyers who try to use 401(k) distributions will incur the 10 percent early withdrawal penalty.
Disability: Taxpayers faced with the tragedy of total and permanent disability can access both their IRA or 401(k) accounts without facing the 10 percent penalty. However, it is critical that they be able to properly substantiate their disability.
Health insurance: IRA distributions can be made without penalty to cover the cost of health insurance for you, your spouse and your dependents following a period of unemployment due to job loss. Qualification is dependent on you receiving unemployment compensation for 12 consecutive weeks.
Military service: In addition to the hardships noted above, IRA or 401(k) distributions by members of military reserves can be made without incurring the 10 percent penalty. This applies if you were ordered or called to active duty after Sept. 11, 2001, for a period of more than 179 days or for an indefinite period because you are a member of a reserve unit.
Substantially Equal Periodic Payments: For taxpayers who are fortunate enough to be able to retire prior to 59½, but need access to their IRA accounts in order to maintain their lifestyle, an SEPP may be an option for taxpayers. Payments are calculated using IRS tables based upon life expectancy. Keep in mind that distributions must occur for the greater of five years or until age 59½. Due to its complexity, an SEPP should be implemented with the help of your tax professional.
Keep your 401(k): Taxpayers who retire after age 55, but prior to 59½ can make penalty-free 401(k) withdrawals for any purpose. However, if you roll your funds to an IRA and then later need to take an early distribution, penalties may apply.
Penalty-free distributions for a beneficiary: While beneficiaries of an IRA or 401(k) currently have the option of rolling the inherited account into an inherited IRA, distributions can be made without penalty by the beneficiary of a retirement account. This is another area where careful planning is necessary.
There are many circumstances which may allow for penalty-free distributions of retirement accounts prior to age 59½. However, most require careful planning and the help of a tax professional. Since everyone’s circumstances are unique, consider speaking to your tax and financial adviser to determine the most appropriate approach for you.
Kurt J. Rossi, MBA, is a certified financial planner practitioner and wealth advisor. He can be reached for questions at (732) 280-7550, kurt.rossi@Independentwm.com or www.Independentwm.com. LPL Financial Member FINRA/SIPC.