How Can You Avoid Early Withdrawal Penalties?

Sometimes life doesn’t follow your carefully crafted financial plan. You hit a rough patch, want to make a big life change or need funds to seize an opportunity.

Whatever the case, you might find yourself eyeing the money in your retirement accounts before you reach retirement age. In fact, nearly half of Americans have taken early 401(k) withdrawals.

And that’s where things get tricky. Withdraw funds too early, and you could get hit with a 10% early withdrawal penalty on top of regular income taxes. But in certain situations, there are ways to access your money without that extra cost.

Let’s walk through when early withdrawals might make sense and what options you might have to avoid penalties.

Key Takeaways

• Early withdrawals (before age 59 ½) from retirement accounts often trigger a 10% penalty
• The Rule of 55 and 72(t) distributions offer two ways to access retirement funds early, if used carefully
• Planning ahead with a financial adviser can help you avoid costly mistakes and keep your long-term financial goals on track

When would someone need to withdraw early?

People consider early withdrawals for a range of reasons – some planned, some not.

A job loss or unexpected medical expense might force your hand. Divorce or buying your first home could trigger the need. Other times it’s about pursuing a dream, like starting a business or taking a career sabbatical.

Many people simply have the luxury of retiring early. For instance, they’ve become eligible for a pension. Or, they’ve pursued the FIRE (Financial Independence, Retire Early) movement and are looking for creative strategies to access funds in their 50s or even 40s.

The key is to understand your options before pulling the trigger. Without the right strategy, you could end up paying thousands in unnecessary penalties.

What counts as an early withdrawal?

An early withdrawal is any money you take out of a retirement account, such as a 401(k) or traditional IRA, before you reach age 59½. (Learn about the difference between pre-tax and after-tax accounts here.)

Unless your withdrawal qualifies for an exception, the IRS will slap a 10% tax penalty on top of the regular income tax owed on that distribution. That can add up fast and derail your financial progress.

What are the exceptions to the early withdrawal penalty?

Thankfully, the IRS does allow for certain exceptions. The rules vary depending on whether you’re taking money from an IRA or an employer plan like a 401(k), but here are some common exceptions:

• Medical expenses that exceed a certain percentage of your income,
• Permanent disability,
• Substantially equal periodic payments (72(t) distributions)
• First-time home purchase (up to $10,000 from an IRA)
• Qualified education expenses (IRA only),
• Birth or adoption of a child (up to $5,000)
• Health insurance premiums while unemployed (IRA only)

Additionally, if you leave your job at age 55 or older (or 50 for certain public service roles), you can take penalty-free withdrawals from your 401(k). This is known as the Rule of 55.

Keep in mind that these are IRS exceptions. Your specific retirement plan might have its own rules, so it’s important to check what your plan allows.

What is the Rule of 55 and how can it help?

If you’re thinking about retiring or leaving your job in your mid-to-late 50s, the Rule of 55 can be a game-changer.

Here’s how it works: If you leave your job (whether you quit, get laid off or retire) in the year you turn 55 or later, you can take withdrawals from your current 401(k) or 403(b) plan without the usual 10% penalty. You’ll still owe regular income taxes, but the penalty goes away.

It’s a tool for those who want to retire early or bridge the gap before other income sources, like Social Security, kick in.

But here’s the fine print: the Rule of 55 applies only to the retirement plan at the employer you just left, not old 401(k)s or IRAs. That’s why it’s so important to coordinate carefully before rolling over any accounts. A misstep could cost you thousands in unnecessary penalties.

What are 72(t) distributions?

For those not covered by the Rule of 55 or who want to access IRA funds early, 72(t) distributions are another option to explore.

Section 72(t) of the tax code allows you to take “substantially equal periodic payments” (SEPP) from an IRA or 401(k) without triggering the 10% early withdrawal penalty.

In simple terms, you commit to taking out a set amount of money each year, based on one of a few IRS-approved calculation methods.

Once you start 72(t) payments, you must continue them for at least five years or until you turn 59½, whichever is longer. If you stop or change the payments early, the IRS will retroactively apply penalties to all prior withdrawals, so this is a strategy that requires careful planning and discipline.

When done correctly, though, it’s a legitimate way to create a stream of income before the typical retirement age.

How can I plan an early withdrawal carefully?

If you think you’ll need to tap retirement savings early, planning is everything.

First, exhaust all other options if you’re experience a financial hardship. Can you adjust your budget? Use emergency savings? Borrow from other sources? Retirement money is often your most expensive money to access early.

If you decide a withdrawal is necessary, especially if you’re prepared to retire early, work with a financial adviser to navigate the rules for your specific situation. Spreading distributions out over several years, using the Rule of 55, setting up 72(t) distributions or some kind of combination, might allow you to access funds while reducing taxes and penalties.

The bottom line

Retirement accounts are designed to provide income later in life, but life doesn’t always follow the plan. If you need to withdraw early, make sure you understand the rules and the potential cost.

There are legitimate ways to access your money without penalties in certain circumstances.

And remember: just because you can withdraw early doesn’t always mean you should. Talking through the options with a professional can help you make the best decision for both today and your future.

Want help navigating your options?

At Advance Capital Management, our advisers can walk you through your retirement accounts and provide personalized strategies for accessing your money – whether it’s today or down the road.

Schedule a call with us and let’s talk about the strategy that works best for you.