Your Guide to Emergency IRA and 401(k) Withdrawals
About the author: Lamar Watson, CFP®, is a Fee-Only Financial Advisor in the Washington, D.C. area that works with clients virtually across the country. Lamar's work with his clients focuses on budgeting, employee benefits, paying down debt, buying their first home, and investing. Lamar is the Founder of Dream Financial Planning, a virtual Fiduciary Financial Planning firm specifically designed to help young professionals and minorities take control of their finances and fulfill their dreams. Feel free to schedule a complimentary consultation to learn how we use the DREAM Financial Planning Process ™ to help our clients achieve their goals.
Download our quick reference guide that covers the most important annual limits and figures for 2022.
Life is complex, and if you find the need to tap into your retirement savings account, you are not alone. In some cases, it may be the right move, or you might not have a choice. According to a recent study, more than half of investors aged 18–34 years have already tapped into their tax-advantaged retirement account.1
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. If you have not reached the age of 59 ½ yet, most retirement plan distributions from these accounts are considered “premature” and are subject to an extra 10% early withdrawal tax.
So what are the exceptions to the 10% early distribution tax? Navigating these rules may help you avoid substantial additional taxation.2 Before you decide to take a premature withdrawal from your retirement account read my blog post, Early 401(k) Withdrawals at a Young Age: What You Need to Know.
IRA and 401(k) Early Distribution Penalty Exemptions
The following are considered qualifying exemptions to the 10% early distribution penalty:
- Age. Withdrawals after the age of 59 ½.
- Death. It may be unfortunate to think about, but any withdrawals after the death of the account holder are not subject to penalty.
- Disability. Total and permanent disability of the account owner.
- “Substantially Equal Periodic Payments.” Under Rule 72(t), setting up substantially equal periodic payments for your life expectancy (or your designated beneficiary).3
- IRS Levy. Do you owe the IRS money? You may be able to cover unpaid taxes using a penalty-free withdrawal.
- Medical. This includes unreimbursed medical expenses in excess of 10% of your adjusted gross income (AGI).
- Military. Qualifying distributions to military reservists during active duty.
- Rollovers. Must be properly executed within 60 days.
- Natural Disaster. Some natural disasters receive temporary, event-specific legislation allowing penalty-free withdrawals on a case-by-case basis.4
IRA Early Distribution Penalty Exemptions
- Education. These include tuition, books, supplies, and other qualified education expenses for you, your spouse, children, and even grandchildren.
- First-time homebuyers may withdraw up to $10,000 without penalty.
- Health insurance premiums incurred during a period of unemployment.
401(k) Early Distribution Penalty Exemptions
- Separation from Service. If separated from service after age 55 (age 50 for certain qualifying governmental public safety employees).
- 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.
Do It the Right Way!
Documentation is important. Make sure you’re saving records and talking to the right people, such as your office human resources department and your financial professional. Hardship withdrawals may require proof once it’s time to pay taxes. It’s important to also keep in mind that any dollar taken out is a dollar that won’t grow or be available for your future 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. Once you’re able, you may want to scale back expenses and set up automatic deposits to ensure that the money is going back into your investment account.
Are you still thinking about making an early withdrawal? Whether your withdrawal falls under the exemption or not, a conversation with a financial professional might be the right place to start.
Dream Financial Planning Process ™
Whether you're managing student loan debt, starting a family, or considering buying your first home, the DREAM Financial Planning Process™ is tailored to the unique needs of busy professionals in their 30s and 40s. This process focuses more on short-term goals while you grow and evolve in your personal and professional life. So if you're looking for guidance on Financial Planning, optimizing employee benefits, budgeting, student loans, and managing your 401k or investments, we can help.
With uncertainty surrounding the economic stability of our country, it's okay to have fears and anxieties surrounding your own savings and investments. The most productive course of action from here is to reach out to Dream Financial Planning (or whoever your trusted advisor might be) and discuss your options. It's easy to have knee-jerk reactions when it feels like the bottom is falling out, but it is imperative to make decisions using research-backed data and a level head. If you'd like a Complimentary Review and risk assessment of your investment portfolio, feel free to send me an e-mail.
In the August Newsletter, I explore how you should invest money for your short-term goals after you've established an emergency fund. I also discuss how a Financial Advisor can help you avoid emotional decision-making with U.S. News and World Report and how to know if your Financial Advisor is the right fit for you. There are also blog posts where I outline how to complete a mid-year financial check-up and 5 college planning mistakes to avoid.
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