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October 20, 2015

How to Avoid Penalty Fees for IRA/Roth IRA/401(k) Early Withdrawal

Every year millions of Americans stash away a portion of their hard earned paycheck into an IRA, Roth IRA, or 401(k) in order to save for retirement.  Unfortunately though, millions more will face penalty fees when taking early withdrawals due to unforeseen job loss, medical expenses, or other financial hardship.  It’s important to understand that if you do take an early distribution from your retirement account you will not only pay income taxes owed on the withdrawal, but will also pay a 10% penalty fee for early withdrawal.

10% Early Withdrawal Fee

The 10% penalty, also known as an excise tax, is assessed if you withdraw from your IRA, Roth IRA, or 401(k) early, i.e. before you have reached the age of 59½.  One easy solution to avoid a penalty is to contribute to a Roth IRA.  Roth IRAs are contributions made after-tax in which one could withdraw from account after 5 years tax-free and penalty-free.  However, you can only withdraw your contributed amount.  So it’s important to keep track of what amount of your Roth IRA is contributed and what has been earned on your contribution.  If you withdraw more than what you contributed, you will be liable for income tax on your earnings and subject to the 10% penalty on your earnings for early withdrawal.

While the above seems like a reasonable solution, most of us contribute to a 401(k) or a traditional IRA to which the after-tax contribution is not an option.  So while early withdrawals are not recommended, below is a list of scenarios in which one can withdraw early without incurring that pesky 10% penalty, because after all, it is “your money”:

  • If you are a first time homebuyer you can elect to take up to $10,000 out of your IRA penalty-free and if you’re married, you and your spouse can each take up to $10,000. The money must be used within 120 days to purchase your home or you will be hit with the 10% penalty. The withdrawal can benefit you, your spouse, your children, parents, or other ancestors to assist in the purchase of their first home.  There is no penalty exemption for the first time homebuyer if you withdraw funds from your 401(k); however, there is a possibility of rolling over the funds into an IRA in order to avoid paying the penalty, but it must be from a former employer.
  • You are also allowed to take an early distribution from your IRA for qualified higher education expenses such as tuition and books. The distribution will still be taxed as ordinary income, but you would be waived of the 10% penalty.  Like with the first time home buyer, your family can also benefit from this exclusion.  Also, same rules apply as above if you are withdrawing from a 401(k).  There is no penalty exemption for qualified higher education expenses, but there is the possibility of rolling over your 401(k) to an IRA and then taking the distribution.
  • You may also withdraw from your IRA or 401(k) early if you have become totally disabled or have incurred unreimbursed medical expenses greater than 10% of your adjusted gross income in the year of withdrawal. Although watch for the timing trap in regards to your medical expenses.  These expenses must be paid in the same year that you take the distribution.
  • Now another less well-known option is to take a 72t early distribution (named after the tax code) which allows you to take a “series of substantially equal periodic payments” which is derived from a calculation using your current age and the size of your IRA. However, once you begin taking these payments, you must continue taking the same amount for 5 years or until you reach the age of 59½ whichever is LATER and even if you no longer need the payments.
  • Another option in the short-term is to take a loan against your 401(k). The IRS allows you to borrow against your 401(k) as long as your employer permits.  If your employer allows you to take a loan, the maximum amount that you can withdraw against is either $50,000 or half of your 401(k) balance, whichever is less.

While the above is not a complete list, it does comprise the most common options taken if an early withdrawal is necessary and you want to avoid the 10% penalty.  In the end, it’s best avoid withdrawing from your retirement funds early.  One of the major factors to having a concrete retirement is the ability to compound your earnings pre-tax. Contact an Anders advisor with any questions on early withdrawal penalties.

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