Saving your money into a 401(k) or IRA can have some very powerful wealth-building benefits.
But clearly one of the biggest drawbacks is that you’re not allowed to access your money for years or even decades. If you try to take it out sooner, than you’ll have to pay a penalty!
So what happens if you need the money now?
What if life becomes difficult and you need to pull the money out for some kind of emergency?
Or what if you have done an excellent job of managing your finances and would like to retire early? How can you work around this problem and gain early access to your savings?
Don’t worry. The IRS knows that sometimes life can throw you curve-balls, and because of this they’ve made several exceptions where it is okay to make a withdraw without paying a penalty.
For those people dealing with hardships in their lives, these exceptions will allow them to use their retirement savings rather than seek out other less-desirable alternatives such as credit cards or high-interest loans.
If you’re planning to retire early, then you will also be able to use some of these strategies to start enjoying penalty-free withdrawals from your 401(k)’s and IRA’s.
The Age 59 1/2 Rule for Retirement Withdrawals
In general, the IRS says that age 59 ½ is when you can start withdrawing your money from a 401(k), IRA, or any other similar tax-deferred retirement savings account. Otherwise you will have to pay a hefty 10% penalty.
Age 59 ½ is when the IRS says that withdrawals (or distributions) from these types of accounts become “qualified”. Therefore, withdrawals before this age would be considered “non-qualified” and subject to the 10% penalty. To illustrate this, for every $10,000 you withdraw early, you would lose $1,000 to this early-withdrawal penalty.
This is why so many people associate age 60 (or older) with retirement. They hear about the early withdrawal penalty and automatically assume that they must wait until they are at least age 59 ½. But as you’ll find out in the rest of the article below, there a lot of ways around this penalty before your 60’s.
Can You Still Work and Make Withdrawals From Your 401(k) at the Same Time?
The answer: It depends. While you’re still working, you’d have to apply for something called “in-service withdrawals” to start taking your money out. It would then be up to the rules of your employer’s plan if they will allow it or not.
By contrast, with an IRA, you can start making withdrawals penalty-free after age 59 ½ without anyone’s permission. This is because your IRA is between you and your financial service provider; not your employer.
The 5 Year Roth 401(k) Rule
If you have a Roth 401(k) instead of a traditional 401(k), in addition to waiting until age 59 ½, one more requirement that you will have to mindful of is that you need to have been contributing to the plan for at least 5 years. Otherwise the distribution will not be qualified and you’ll owe the 10% penalty.
So let’s say you start a job at age 56 and contribute to a Roth 401(k). You’d now have to wait until age 61 to start making penalty-free withdrawals.
How to Make Penalty-Free Withdrawals From Your Retirement Savings Before Age 59 ½
Again, you absolutely don’t need to always wait until age 59 ½ to start making withdraws from your 401(k), IRA, or other retirement savings accounts. There are lots of ways around this rule, and I’m going to teach you how!
In fact, as someone who’s determined to achieve financial freedom, I was so interested in this topic that I researched it for years and collected everything I learned into an ebook called “How to Unlock Your Savings Before Age 59 ½ Without Penalty“. If you’d like to retire early, please check out it to learn a lot more about how each of these strategies might work better for you.
Take Out a Loan From Your 401(k)
One of the classic and temporary options for taking money out of your 401(k) penalty-free is to simply borrow from it by taking out a loan. (Yes, you’re effectively borrowing from yourself.)
Assuming your 401(k) plan allows loans (not all do), the IRS says you’re allowed to borrow the lesser of $50,000 or half of your vested account balance. Afterwards, you’ll have to pay it back with interest in no more than 5 years.
A warning against 401(k) loans …
While borrowing against your 401(k) can be useful if you’re in serious financial trouble, it is important to keep in mind what you will be giving up. Once the money have been removed from 401(k), it is no longer there to compound and grow. Though that may not sound like a big deal now, it could be very significant in the future when you’re ready to retire.
For example, imagine you’re 60 years old and had saved $1,000 each month towards retirement for the past 35 years. At a rate of 7%, you’d have $1,801,055. But wait … What if you lost 5 years of compounding power because you took out a loan against your 401(k)? Now your savings would only grow to $1,219,971. Big difference!
Can I borrow from my IRA too?
IRA’s do not allow you to take out a loan in the same way that 401(k) plans do. With an IRA, you are allowed to take your money out for up to 60 days. Though this is generally intended for you to be a time to make a rollover from one financial provider to another, some people will also use this rule to treat it as a sort of short-term loan.
Again, everyone knows that sometimes “life” happens. You get hurt, someone in your family becomes ill, you need to send the kids to college, your house gets damaged, etc.
The IRS knows these things tend to happen. So rather than force people to look to some kind of immediate but undesirable financial relief such as credit card debt or high-interest loans, they have approved several circumstances where penalty-free withdrawals are okay.
These are called “hardship distributions“, and are as follows:
- Medical care expenses
- First time home purchase
- Higher education expenses (tuition, fees, room and board, etc.)
- Payments necessary to prevent eviction or foreclosure
- Funeral expenses
- Repair damage to your home
If you plan to withdraw this money from your 401(k) instead of your IRA, remember that it will first need to be allowed by your employer’s plan. Check with your human resources department to know for sure.
The Age 55 Rule
If you’d like to retire and are only a couple of years away from age 59 1/2, then you’re in luck!
When it comes to 401(k)’s and 403(b)’s, the IRS has a special exception known as the Age 55 Rule where you can start making penalty-free withdrawals starting in the year you turn age 55.
In order to do this:
- Your employer-sponsored plan must allow for it.
- You must leave your employer no sooner than the year you turn age 55 (either by your terms or theirs).
- If you quit your job at age 56, then you should be okay to start making withdrawals.
- If you are fired from your job at age 54 and don’t turn 55 until next year, then you won’t be allowed to access your 401(k). For the same example: If you were going to turn 55 that same year, then you’d be okay.
Can you also withdraw from 401(k) plans from previous employers at age 55?
Unfortunately if you’ve got 401(k) plans sitting around from your old job(s), these won’t qualify for withdrawal since you technically left before age 55. But here’s a tip: Roll those old funds over into your current 401(k) or 403(b) so that they become part of your total balance. Just be sure to do so before you leave your current job.
Does the Age 55 Rule also work with IRA’s?
Unfortunately, no. IRA’s have no such exception.
When it comes to Roth IRA’s, one helpful benefit is that the contributions (the money you put in) can be withdrawn anytime you want. Why is this allowed? Because technically you’ve already paid taxes on them.
Therefore, if you need to pull out these contributions for an emergency need or to bridge the years between when you retire early and age 59 1/2, then you will be able to do so.
What’s not allowed for withdrawal is the earnings portion of your Roth IRA (the money that grew on top of the money you put in). Because you never paid taxes on these earnings and it’s still before age 59 1/2, they would be subject to the same 10% penalty for non-qualified distributions.
Can I Withdraw the Contributions From My Roth 401(k)?
Unlike with a Roth IRA, withdrawing your contributions from a Roth 401(k) before age 59 1/2 is not as simple.
When you make an early withdrawal from a Roth 401(k), the entire withdraw is treated on something called a “pro-rata basis”. What does that mean? It means your withdrawal will be considered a mixture of qualified vs non-qualified; your contributions and earnings.
As you might guess, the IRS will expect that you pay taxes on the earnings proportion (non-qualified) and no taxes on the contribution portion (qualified).
Using a 72(t) to Make SEPP’s
Another helpful way to take penalty-free withdrawals from your IRA or 401(k) is to use a little-known IRS exception called a 72(t).
Under section 72(t) of the IRS tax code, you are allowed to make what’s called a “series of equal periodic payments” or SEPP’s. These SEPP’s can be calculated using one of three methods:
- Required Minimum Distribution – Distribution is found by dividing the account balance by the life expectancy of the tax payer and beneficiary. The amount changes year to year.
- Fixed Amortization Method – Calculated as an annuity based on the tax-payer and beneficiary’s age versus a mortality table. The amount is the same each year.
- Fixed Annuitization Method – Calculated by dividing the account balance against the life expectancy of the tax-payer and beneficiary. The amount is the same each year.
Once you start an SEPP, you will have to continue to make these payments for at least 5 years or until you turn age 59 1/2, whichever is greater. So plan conservatively so that you do not run out of money too soon!
Be sure to work with a tax professional to help you calculate and document your SEPP’s correctly. If you take out the incorrect amount, it could mean a penalty.
Although SEPP’s are allowed for both IRA’s and employer sponsored plans like a 401(k) or 403(b), you may find that an IRA is easier to work with. Remember that when it comes to employer sponsored plans, your employer (the plan administrator) has to allow for these types of withdrawals. From personal experience, I discovered my old employer did NOT allow SEPP’s. So what’s the work-around? When you leave your employer, roll your 401(k) into a traditional IRA. Once the money is in the IRA, it will be under your control, and you are then free to make SEPP’s as you see fit.
Backdoor Roth IRA Ladder
Another creative way to put your retirement savings into a place where it can be more easily withdrawn is to create what’s called a Backdoor Roth IRA Ladder.
The way this works is to first move your 401(k) or 403(b) into a traditional IRA. Once this is done, you then will make small conversions each year from your traditional IRA to a Roth IRA. By doing this, each conversion becomes a “contribution” to your Roth IRA and it becomes available for a penalty-free withdrawal in 5 years. Do this year after year, and starting on year six you will be able to enjoy a steady stream of penalty-free retirement income!
Because Roth conversions can be any amount, this trick allows you to contribute a lot more money into your Roth IRA beyond the normal $6,000 annual limit. This “back door” loop-hole is also how high-income earners can still contribute to a Roth IRA even though they exceed the IRS income limits.
Taxable Investments Like Capital Gains and Dividends
One of the most obvious and under-appreciated place to get penalty-free access to your retirement savings is to put it into taxable investment accounts.
Yes, I said taxable. Unlike the tax advantages you get when using traditional or Roth retirement accounts, taxable accounts are just that – subject to taxes. But these taxes might be far less than you think.
How so? When it comes to investments such as stocks that produce dividends and capital gains, this income is subject to different rules than the money you earn at your job (earned income). For example, if you and your spouse have a MAGI less than the 22% tax bracket when you file your Federal tax return, you might not owe any taxes on these earnings at all. Click here for a complete chart.
And the best part: Your taxable savings is always under your control. Unlike a 401(k) where you have to check with your employer to see if the plan allows for withdrawals, the choice to cash-in your taxable investments is always yours alone to make.
Retirement Income After Age 59 ½
Though most of our tax-deferred retirement savings becomes available by age 59 1/2, these are not the only sources we need to think about.
Below are two very important areas of retirement that will be impacted.
Social Security Income
Remember all those Social Security deductions that were taken out of your paycheck all throughout your working years? You finally get to start claiming them back.
Starting at age 62 (depending on the year you were born), you may be eligible to apply for Social Security distributions. How much you’re eligible to receive will depend greatly on a number of different variables such as what age you start collecting, how much you’ve contributed over the years, spousal benefits, etc. To know for sure, login to the Social Security website and use their calculator to see what your expected benefit will be.
Will Social Security even still be around by the time I retire?
The short answer is “yes”, but you most likely won’t receive everything you’re entitled to.
Because the program is currently underfunded, Social Security’s own website says that starting in 2035 that you should expect a payout approximately 80 cents for every one dollar of benefit you’re entitled to. While that’s not full amount, it’s also much, much better than the doom-and-gloom picture that some people like to paint.
Required Minimum Distributions
In an effort to avoid people leaving their savings in a tax-deferred account for forever, starting at age 70 1/2, the IRS will require you to start making withdrawals every year called “required minimum distributions” or RMD’s for short.
RMD’s have sometimes been called a “reverse hold-up” because it is a way for the government to effectively force you into withdrawing your own money. Why would they want you to do this? Because once withdrawn, you can finally start paying taxes on it.
What happens if you don’t take on an RMD? Then you have to pay an absurdly huge 50% penalty on the difference. Ouch! To put that in perspective, let’s say you forget to withdraw $10,000 from your traditional 401(k) or IRA. This means you’d now have to pay a HUGE $5,000 penalty to the IRS!
While RMD’s often get a bad rap, keep in mind that just because you withdrew your money doesn’t mean you have spend it. Once withdrawn, you could always put it into a taxable investment account with stocks that generate dividends and capital gains. Using this strategy, you could then continue to enjoy potentially lower taxes for years to come.
Make Sure You’re Fully Vested In Your 401(k) First
Before making any withdrawals from your 401(k), it’s worth mentioning that you’ll want to make sure you’re fully vested in your 401(k) before you leave your job.
What is vesting? Vesting is a system adopted by many 401(k) plans where you gradually retain the rights to all the money your employer has contributed.
Generally with 401(k) plans, you always own all the money you’ve contributed. But some 401(k) plans have rules where you need to work a certain number of years before the money they’ve contributed belongs to you. If you quit before then, than their contributions are taken back and distributed back into the plan to those still working.
For example, with my old job, for each year of employment you became 20% more “vested” in your 401(k) plan than the year before. So when it came to my employer’s contributions, after the first year I’d own 20%, the second year 40%, and so on. Basically, you had to work there at least six years into order to not lose any of your 401(k) balance if you were thinking about switching to another employer. This is exactly why employers use vesting. It can be a useful motivator to keep employees working for them over the long-term.
So when it comes to making your withdrawals, if you’ve only worked for your employer a short amount of time, make sure to understand their policy on vesting so that you don’t potentially lose any of their contributions.
For more easy to follow information about how 401(k) vesting works, check out are post here.
The Most Important Thing to Remember: Don’t Run Out of Money!
Even though we just explored a multitude of ways to access your retirement savings before age 59 /12, if there’s one thing I can’t stress enough, it’s this: No matter what your plan for retirement looks like, make sure you create your plan in such a way that you won’t risk running out of money.
Hey, I get it! As someone who’s looking forward to an early retirement, the knowledge that you can use these strategies to get access to your retirement savings decades before you’re supposed to is really cool and exciting! But it could also be VERY tragic if you don’t make a plan that includes plenty of buffer for unforeseen events. How terrible would it be to enjoy retirement for a few short years only to drain yourself of all of your life savings and try to go back to work at an elderly age. Please be sure that you crunch the numbers using multiple variables and plan your withdrawals conservatively.
Photo credits: Pexels, Unsplash