There’s no way to tell where life may take you and that’s what makes it exciting and unsettling at the same time. No matter how much you plan for a smooth journey, there’ll always be a bump in the road, road construction, or traffic jams that redirect you on another path or force you to make compromises.
This reminds me of the song “Ironic” by Alanis Morisette. Although what she said was not actually ironic, the song paints a picture of how inconveniences can happen in the most inopportune times.
Life is complex, and though you have a sound retirement strategy, you may one day face circumstances that require you to tap into your retirement savings account. Here’s some reassurance: you are not alone. According to a recent study, 51% of Americans have taken an early withdrawal.
IRA and 401(k) accounts are essentially a deal with the government. In exchange for investing for retirement, the government allows preferential and/or deferred tax treatment. Most distributions from these types of accounts before the age of 59½ are considered “premature” and are subject to an extra 10% early withdrawal tax.
So, you may be asking: Is it possible to avoid the 10% early withdrawal tax? Knowing and navigating these rules may help you avoid substantial additional taxation.
The following are considered qualifying exemptions for the 10% early distribution penalty for both IRAs and 401(k)s:
1. Age. Withdrawals after the age of 59½.
2. Death. It may be uncomfortable to think about, but it is worth knowing that any withdrawals after the death of the account holder are not subject to penalty.
3. Disability. Total and permanent disability of the account owner.
4. “Substantially equal periodic payments.” Under Rule 72(t), setting up substantially equal periodic payments for your life expectancy (or your designated beneficiary).
5. IRS levy. Do you owe the IRS money? You may be able to cover unpaid taxes using a penalty-free withdrawal.
6. Medical. This includes unreimbursed medical expenses in excess of 10% of your adjusted gross income (AGI).
7. Military. Qualifying distributions to military reservists during active duty.
8. Rollovers. When you roll your 401(k) funds to an IRA, you may potentially avoid both the 10% penalty and the 20% tax withholding in the process. It’s important to note that this option is only available if allowed by your employer.
9. Natural disaster. Some natural disasters are covered by temporary, event-specific legislation that allows penalty-free withdrawals on a case-by-case basis.
You can take early withdrawals from a traditional and Roth IRA penalty-free in the following instances:
1. Education. This includes tuition, books, supplies, and other qualifying education expenses for you, your spouse, your children, and your grandchildren.
2. First-time homebuyers. You may withdraw up to $10,000 without penalty to purchase a home if you’re a first-time homebuyer (have not owned a home in the past two years). You can also use the funds withdrawn to help a parent, child, or grandchild who must satisfy the “first-time homebuyer” requirement, to buy a home.
3. Health insurance premiums. Premiums incurred during a period of unemployment.
Additionally, here are instances where you can avoid the 10% penalty if you plan to tap into your 401(k):
1. Separation from service. If separated from service after age 55 (age 50 for certain qualifying governmental public safety employees).
2. Loans. If allowed by the plan, you may qualify for a 401(k) loan. It is not a withdrawal, but the account is treated as collateral.
Documentation is important. Make sure that you save all records and talk to the right people, such as your office human resources department and your financial professional. Hardship withdrawals may require proof at tax time. It’s important to also keep in mind that any dollar withdrawn is a dollar that won’t grow or be available during your retirement.
If you have to dip into your retirement account, don’t despair. You may have more time to recover than you initially think. Steady progress is important, starting with re-filling your emergency fund and paying off any high-interest debt. When you’re able, scale back your expenses and set up automatic deposits to ensure that money is going back into your investment account.
Taking early withdrawals from your retirement funds may be top-of-mind when faced with an urgent and unexpected need for cash. However, it should be your last resort as there are other options that you can rely on like a home equity loan, bank or credit union loan, or zero-interest credit card.
Are you still thinking about making an early withdrawal? Whether your withdrawal is exempt from penalty or not, a conversation with a financial professional might be the right place to start.
The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your financial advisor, attorney, or tax advisor. For additional information and disclosures, please visit our website at www.mbewealth.com. MBE Wealth Management, LLC is a registered investment advisor.
This content is developed from sources believed to be providing accurate information, and provided by Twenty Over Ten. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.