When you reach age 59.5, you can withdraw money from your 401(k) or other retirement accounts penalty-free. Withdrawals before that age incur a 10% early withdrawal penalty. This creates a dilemma for those who want to retire early and need access to liquidity before they reach that age.
But what many people don't realize is that there are a few perfectly allowable loopholes you can use to tap into these funds without incurring the penalty. There are rules that allow for hardship withdrawals, such as in cases of disability or a natural disaster. However, for this article, we will focus on distributions that can be used for any purpose.
Please be aware that some of these strategies are complex and may require additional tax filings. If you are considering these options, consult your advisor or tax preparer for guidance.
60-Day Rollover
If you need cash in a pinch and can repay yourself within a short time, utilizing the 60-day rollover rule is a quick and inexpensive option. This rule allows you to withdraw funds from a retirement account, such as a 401(k) or IRA, and avoid the 10% early withdrawal penalty if you can repay the full amount within 60 days. It also won’t count as taxable income if it comes from a pre-tax account.
If you are married and your spouse also has a retirement account, you can stretch this to 120 days by replenishing funds in one of your accounts, with funds from the other’s account, and then paying that one back after another 60-day period.
We’ve seen this commonly used by clients to fund a down payment on a new home that is needed before they sell their current home. Once their current home is sold, the proceeds can be put back into their retirement account, and no penalty or taxes apply.
One important thing to note about this rule is that you can only do one 60-day rollover within a 12-month period.
Roth IRA Contributions
One of the really great features of Roth IRAs is that you can withdraw your Roth IRA contributions at any time, for any reason, without incurring taxes or penalties.
For example, let’s say you have a Roth IRA that you’ve contributed $50,000 to over the years, which is now worth $100,000 due to the growth of the assets. You can take the $50,000 out, even if you are not 59.5, without incurring the early distribution penalty. The remaining $50,000 may be subject to taxes and penalties if withdrawn early.
401k Loan
If your employer’s plan allows it, the IRS permits you to take a loan from your 401(k). The loan can be up to $50,000 or half of your vested balance, whichever is lower. Rather than pay interest to a lender, you pay interest back to yourself, at a rate set by the plan. This option can be quicker and require much less paperwork than getting an outside lender.
However, there are some downsides. You have to pay yourself back with after-tax money, which means you’ll be taxed twice if you eventually withdraw money down the road in retirement. There’s also the opportunity cost of lost market returns while the loan is outstanding. Most importantly, you may be required to repay the loan in full if you leave your job. If you cannot repay the loan, it will be treated as a distribution, which would incur taxes and the 10% penalty if you are not at least 59.5 years old.
Substantially Equal Periodic Payments or 72(t) Rule
The IRS allows people under 59.5 to withdraw money from their retirement accounts if the distribution is part of a series of substantially equal payments over the course of five years or until age 59.5, whichever is longer. You are still taxed on these distributions, but you won’t be on the hook for the 10% early withdrawal penalty.
This is the most complicated option and has very strict guidelines for calculating the payment amount. Once it is established, you can no longer contribute to the account or take additional distributions.
Given the complexities of this strategy, we strongly recommend seeking help from a financial professional or tax advisor if you are considering this option.
Rule of 55
When you hit age 55 (or older), you can utilize the “Rule of 55” if you lose your job or retire early. This allows you to withdraw money from your 401(k) at your most recent employer without incurring the 10% early withdrawal penalty if you are no longer working there.
Unlike the 72(t) rule, no calculations are necessary, and there are no restrictions on the timing or amount you can withdraw, making it one of the most flexible options
Please note that this does not apply to IRAs or retirement plans still held in a previous employer plan. This is a frequently overlooked reason why you may want to roll 401(k) dollars from a previous job into your current employer’s retirement plan.
If you have any questions or want to discuss this in more detail. Feel free to reach out to me at nick@slaytonlewis.com. Thank you.