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Penalty-Free Ways to Raid a 401(k)

Thinking about raiding your retirement funds? There are ways to do so without triggering the dreaded 10% penalty on early withdrawals.

First a little background. When you save in a tax-deferred 401(k) or Individual Retirement Account, Uncle Sam lets you contribute money on a tax-deferred basis. You don’t have to pay income taxes until the money is withdrawn. To encourage people to save for retirement, the IRS imposes a 10% penalty on those who break into these accounts before reaching age 59 1/2.

But there are ways around the 10% penalty.

For example, if you leave a company in the year in which you turn 55 or older, you can take penalty-free withdrawals from a 401(k) plan. (The distribution would be taxable, of course, but the 10% penalty would not apply.) The rules are strict: If you are 54 when you leave your job, you can’t escape the 10% penalty–even after turning 55.

Be aware that you can only take penalty-free distributions from the 401(k) account of the employer you left on or after your 55th birthday.

If you are laid off between ages 55 and 59 1/2 and anticipate needing some of your retirement money to make ends meet, it’s a good idea to leave at least part of your savings in your 401(k) plan, rather than rolling it over to an IRA, says Ed Slott, an IRA expert in Rockville Centre, N.Y.

401(k) owners “should always leave more in the (401(k)) plan than” they might think they will need, he says. People “always seem to need more money than they think.”

There are also ways to avoid a 10% penalty with an IRA.

IRA owners, for example, can take so-called 72 (t) withdrawals. The advantage to these is that you can start them at any age. The downside: Once you start taking 72 (t) withdrawals, you must continue for either five years or until you reach 59 ½–whichever is longer. That means a 58-year-old is locked into receiving annual payments until age 63. A 35-year-old faces 24 1/2 years of drawdowns. Moreover, because the payments are calculated according to actuarial tables, you won’t have flexibility to adjust the amounts. (You can do it with a 401(k), but you must have left the company first.)

Yet another way around the 10% penalty applies to IRA owners who are unemployed. They can take distributions from a SEP, SIMPLE, Roth or traditional IRA to pay health insurance premiums for themselves, a spouse, and/or dependents. (Note: You cannot do this with a 401(k).)

Be sure to follow the rules, says Mr. Slott. For example, to qualify, you have to have received unemployment compensation for at least 12 consecutive weeks, he says. Moreover, you must take IRA distributions either in the same year you receive unemployment benefits or in the following year, he writes. And you must pay your health insurance premiums in the year you take the distributions.

Self-employed people who don’t qualify for unemployment benefits, can take advantage of penalty-free withdrawals, too, provided that “they would have met the unemployment benefits requirement had they been an employee,” Mr. Slott writes.


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About Encore

  • Encore examines the changing nature of retirement, from new rules and guidelines for financial security to the shifting identities and priorities of today’s retirees. The blog also explores news that affects retirement, from the Wall Street Journal Digital Network and around the web. Lead bloggers are reporter Catey Hill and senior editor Jeremy Olshan. Other contributors include The Wall Street Journal’s retirement columnists Glenn Ruffenach and Anne Tergesen; the Director for the Center for Retirement Research at Boston College, Alicia Munnell; and the Director of Research for Pinnacle Advisory Group, Michael Kitces, CFP.