Ways to tap retirement funds early without a tax penalty

GENERIC nest egg 401(k) retirement

For most Americans, the employer-sponsored 401(k) account is truly essential to their retirement. Eighty percent of full-time workers have access to these plans, and 88 million actually participate in them. Photo Credit: iStock

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Workers are retiring earlier these days, whether by choice or not, and many find they need to withdraw funds from retirement accounts prior to age 59½. That's the age when account holders can take distributions from 401(k) plans and traditional and Roth IRAs without a 10 percent penalty.

Tax law makes early withdrawals difficult without penalty, but if you need to tap the resources in your retirement accounts early, you have options.

If you have a Roth IRA, for example, you can withdraw the principal of any contribution without penalty. For example, assume you have $6,000 in your Roth account ($5,000 in contributions plus $1,000 in dividends, interest income and appreciation). Even if you are 55, and some of your contributions were made less than five years ago, you can withdraw up to $5,000 without penalty.

Now, 401(k) plans don't allow early distributions while a person is employed with the company, but many allow employees to take loans from their own accounts. These loans can be useful, but they have disadvantages. One of the most significant is that that the loan must be paid in full if the employee leaves his or her employer. Any part of the loan balance that is not paid back is assessed a 10 percent penalty, plus ordinary income tax liability.

Suppose, for example, you borrowed $5,000 from your 401(k) and repaid $3,000. If you leave your job, unless you repay the outstanding $2,000, you will owe the IRS a $200 penalty and you will be subject to ordinary income tax liability on the $2,000. Do not take out the loan unless you can repay it before you leave your job.

Many experts discourage 401(k) loans because of potentially high interest rates. This is one of my pet peeves. The interest rate you incur is not an important issue, since you are paying the interest to yourself.

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With IRA accounts, and with employer-sponsored retirement plans, when you're no longer with the company, there is a way to take regular yearly withdrawals before age 59½ without the 10 percent penalty. These are known as "substantially equal periodic payments" or SEPP, and you may elect one of three methods for calculating the amounts of the distributions: the required minimum distribution (RMD), using IRS tables; the fixed amortization method; and the fixed annuity method.

The RMD method is simplest. The amount you must withdraw is recalculated annually. The latter two methods generally produce much higher payments, which will deplete your account balance sooner.

Whatever option you choose, you may not withdraw more (or less) than the computed amount without incurring retroactive penalties on all payments. Accordingly, make sure you understand the restrictions. Your SEPP program remains in place for five years, or until you reach 59½, whichever comes later, and you get one chance to change the calculating method, if you wish.

IRS Publication 590 references the options but does not go into detail. You can discuss them with your financial planner, tax adviser or retirement specialist.

Certain life events allow you to take distributions early, within limits.

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If you become disabled, you may take them as if you were 59½.

You may take withdrawals penalty-free from IRAs and traditional 401(k)s for medical expenses if they exceed 10 percent of your adjusted gross income (7.5 percent if you or your spouse was born prior to 1949).

You may withdraw from your IRA, without penalty, $10,000 ($20,000 for a couple) if you use it for the purchase, building or rebuilding of your first home, with certain restrictions.

However, in all these situations, even though you will not incur the 10 percent early-withdrawal penalty, your tax liability will be computed in the same way it would be for regular distributions taken after age 59½. See IRS Publication 590 (irs.gov/publications/p590).

Although I have referred to options that will allow you to make withdrawals without penalty, you should consider other options first. The longer you are able to allow your retirement accounts to grow via compounding, the better off you will be. Tax laws are designed to benefit you the most if you are able to keep your funds invested for as long as possible -- even post-retirement. However, if you are forced to make withdrawals prior to 59½, select the most cost-effective options.

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Elliot Raphaelson is a financial columnist for Tribune Content Agency.

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