How to Make Penalty Free Early Withdrawals from your Retirement Accounts



Starting a Retirement Account


According to a recent Motley Fool Article 55% of Americans have some sort of a retirement account.  Not great, but its a start.  Retirement account options vary from company sponsored 401(k)s, individually held IRAs, ROTH IRAs, and many others. 


Retirement plans offer great tax advantages, in that they either allow you to invest your money tax free, or else they allow you to withdraw it tax free.


The Caveat


Unfortunately Retirement accounts usually come with one pretty significant catch.  You can’t access your money until you reach age 59 and 1/2.  Or rather, you can’t access your money penalty free.


In Order to make an early withdrawal from your retirement account you are automatically hit with a 10% penalty.  Ouch. 


But what if you unexpectedly need the money now and can’t wait 20 years?  What if you hit a financial hardship?  Or what if you decide you’ve got enough money to retire now, but aren’t yet ‘old enough’?  Thankfully there are a few ways around this penalty, which I’ll outline below.  Some of these strategies are well known, while One you’ve probably have never even heard of before.


Early Withdrawal. What are my Options?


The 401(k) Loan

Many company-sponsored 401(k) Retirement plans allow you to take out a loan against your account.  This allows you to withdraw your money without paying a penalty, provided you pay it back in accordance with the terms of the loan.  You’ll still have to pay interest on this type of loan, but you’ll be paying interest to yourself, so you aren’t really out anything except the capital gains you would have achieved had you kept the money invested.


Be careful though, if you are laid off, a 401(k) loan must usually be repaid in full within 60 days.


The Roth IRA

Roth IRAs are unique in that you get no tax deduction when making a contribution to your account, but the gains appreciate tax free, and can be withdrawn without accruing any sort of taxes afterwards.  Pay taxes now so you can avoid them later.


Another really cool thing about Roth IRAs is that the principal can always be withdrawn, at any age, penalty & tax free.  As long as you’ve contributed more money than you need to take out, you can do so without extra taxes, and without penalties.


IRS Rule 72(t) SEPP

Now here’s for the rule you’ve almost certainly never heard of.  This is the rule for you if you’ve diligently invested your money for years and years, finally achieving enough savings to retire, only to realize you’re still not ‘old enough’.  What a great problem to have. 


Under the IRS 72(t) exception, you can make Substantially Equal Periodic Payments (SEPP) from your retirement account to yourself starting at ANY AGE!


With this rule you can essentially declare retirement tommorrow.  At 29.  At 36.  At 45.  Even if all of your money is locked away into your retirement accounts.  


You must be careful taking this route though as the requirements are strict and the consequences for failing to follow them are severe.  The requirements are essentially that you must make “substantially equal” withdrawals from the account every year for at least 5 years, or until you turn 59 and 1/2 (which ever is later).


Here are the full rules laid out by the IRS:  “If distributions are made as part of a series of substantially equal periodic payments over your life expectancy or the life expectancies of you and your designated beneficiary, the §72(t) tax does not apply. If these distributions are from a qualified plan, not an IRA, you must separate from service with the employer maintaining the plan before the payments begin for this exception to apply. If the series of substantially equal periodic payments is subsequently modified (other than by reason of death or disability) within 5 years of the date of the first payment, or, if later, age 59½, the exception to the 10% tax does not apply. In that case, your tax for the modification year is increased by the amount that would have been imposed (but for the exception), plus interest for the deferral period.”


So basically if you don’t follow the SEPP rules exactly you’ll be on the hook for taxes plus interest on your withdrawals.


How do you calculate the SEPP withdrawal amount?

There are three ways to calculate the withdrawal amount, and they with all result in different amounts, but all are acceptable to the IRS.  They are outlined below:


Required Minimum Distribution

This is the easiest way to calculate your annual distribution.  Basically, you divide your account balance by your remaining life expectancy, and withdraw that amount for the year.  On December 31st, you then divide your new account balance by your remaining life expectancy and with draw that amount the following year (and so on).


Fixed Amortization Method

Basically this is the same as the RMD method, except that instead of rebalancing your account on December 31st of every year, you continue to withdraw the same amount you did the first year, regardless of your current account balance.


Fixed Annuitization Method

This is the last, and definitely the most complicated of the methods.  The IRS defines this method as follows: The annual payment for each year is determined by dividing the account balance by an annuity factor that is the present value
of an annuity of $1 per year beginning at the taxpayer’s age and continuing for the life of the taxpayer (or the joint lives of the individual and beneficiary). The annuity factor is derived using the mortality table and using the chosen interest
rate. Under this method, the account balance, the annuity factor, the chosen interest rate and the resulting annual payment
are determined once for the first distribution year and the annual payment is the same amount in each succeeding year


You are allowed to switch methods only once penalty free, and only from the fixed annuity or amortization method back to the Required Minimum Distribution method.  Due to the stringent rules of this exception, It is helpful to have multiple retirement accounts, and only to use the SEPP method on a handful of them, leaving your remaining accounts with more flexibility.

For more detail on workplaces retirement accounts specifically, please check out How to evaluate the options in your retirement savings plan

For more tips and Financial advice check out my latest blog posts: Ask The Savings Guy





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