Early Access: A Guide to Penalty-Free 401(k) and IRA Withdrawals Before Age 59.5
Planning for retirement is crucial, but unexpected events can (and do) arise. While retirement accounts offer long-term tax benefits, accessing those funds before age 59.5 typically incurs penalties.
If you need money, we usually recommend treating retirement accounts as a last resort. Those dollars should be there to support you after you’re done working (but still need income). And everyone knows that the longer you give it, the better chance investment accounts have to grow.
However, life does happen on occasion and if you need to tap your retirement accounts before age 59.5, there are ways to do so that can save you from penalties, taxes, or both.
IRS Section 72t Distributions avoid the 10% Early Withdrawal Tax Penalty
If you’re under age 59.5, you can still take distributions from IRAs or 401(k) plans without the additional 10% penalty. Here’s how 72T (otherwise known as substantially equal periodic payment plans) work:
“According to IRS Section 72(T)(2)(A)(iv), if the distributions are determined as a series of substantially equal periodic payments (called a “SoSEPP”) over the taxpayer’s life expectancy (or over the life expectancies of the taxpayer and the taxpayer’s designated beneficiary), the 10% additional tax does not apply.”
The 72T must be based on both life expectancy and an interest rate. You can play with calculations on Fidelity’s 72T calculator here
Once calculated and the periodic distributions begin, they need to remain unmodified for at least 5 years and until you reach age 59.5. You can’t add anything additional or pull anything extra from the IRA or 401(k) while the 72T plan is underway. Modifications can trigger current penalties and back taxes of the 10% early withdrawal penalty.
If you’d like us to help you set up a 72T payment plan, schedule an appointment here
Avoiding Early Withdrawal Penalties on 401(k) Plans
401(k) plans offer a few ways to avoid penalties on early distributions. Every plan is designed differently, so you’ll need to double-check with your HR or Plan Administrator which of these provisions might apply to you.
401(k) Loans
Taking a loan from your 401(k) is a common way of accessing the money while avoiding state and federal income tax. The maximum you can take is usually the smaller of $50,000 or 50% of your account balance.
Loans aren’t free money though; you’ll need to pay the balance back over 5 years (through payroll deferral), with interest.
401(k) Hardship Distributions
Retirement plans sometimes allow for early (but still taxable) distributions that avoid a 10% early withdrawal penalty. The IRS describes hardship distributions as “immediate and heavy financial need”, and can include: Medical expenses, tuition, funeral, or expenses related to buying, repairing, or preventing eviction from a personal residence.
Age 55 401(k) Distributions
Many people incorrectly assume there’s a 10% early withdrawal penalty on 401(k) distributions before they turn age 59.5. Thank IRAs for the confusion.
While distributions are still subject to income tax, they avoid an early withdrawal penalty if taken directly from a 401(k) after age 55.
Be careful though: If you roll your 401(k) into an IRA, you’ll have to play by the IRA’s rules and wait until age 59.5 to avoid penalties.
Also remember that a 20% federal income tax is applied to the distribution, which acts as a tax estimate until you file your tax returns.
Avoiding Early Withdrawal Penalties on IRA Distributions
IRA’s (or Individual Retirement Account), is a special savings account designed to help you save for retirement with tax benefits. Money is usually deductible from tax going in and taxed as income upon distribution. Withdrawals before age 59.5 are subject to an early 10% penalty in most cases except these:
72T periodic plans (see above)
60-Day IRA Rollover
The IRA 60-Day Rollover Rule provides IRA owners the opportunity to withdraw funds tax-free from their accounts if they redeposit them within 60 days. When done properly, they can completely avoid incurring income tax or early withdrawal penalties. This can only be performed once per year.
The 60-day rollover works well for avoiding tax on short-term transactions. Many clients have used this as “bridge financing” between closing on the purchase of one asset and the sale of another. But be careful, the 60-day rollover is not flexible on timing. At 61 days and beyond, the money can’t be re-deposited and you’ll get a 1099 (with any penalties) for the full amount.
Tax-Free Roth IRA Withdrawals
Roth IRAs have some of the most flexible withdrawal rules due to their after-tax nature. Under normal rules, distributions after age 59.5 are 100% tax-free. Before that, Roth IRA owners have some additional flexibility:
Return of contributions
Roth IRAs allow you to withdraw your total contributions tax-free and penalty-free at any time. For example, if you’ve contributed $5,000 to your Roth IRA four years in a row, you can pull out up to $20,000 tax and penalty-free at any time or age.
However, any earnings distributed before the owner is age 59.5, and/or the account being open for 5 tax years will be subject to ordinary income tax and a 10% penalty.
Roth IRA 60-Day Rollover
Similar to the 60-day IRA Rollover rules above, Roth IRA dollars can be withdrawn and redeposited for up to 60 days with no income tax or penalty. The timeline is rigid, and funds must be coded correctly as they’re redeposited.
Final Disclosures:
You can read more about all the strategies above at IRS.gov
Consult your plan administrator, CPA or financial advisor for your specific plan details.
Early withdrawals reduce your retirement nest egg and its future earning potential.
By understanding these options, you can access your retirement savings strategically when needed.