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13 Ways to Dodge Penalties for Retirement Plans

It’s a last-ditch option, but you can make early withdrawals a bit less painful

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To financial planners, taking an early withdrawal from a tax-deferred retirement account is nearly as bad as planning on winning the lottery to pay your child’s college tuition. But sometimes, an early withdrawal is the best of many bad choices — and Congress has made it a bit easier to take money from your retirement account, penalty-free. You’ll still have to pay taxes on what you withdraw, however.

What’s wrong with tapping your 401(k) or IRA? In most cases, taking money from a traditional IRA, 401(k) or similar tax-deferred account before you reach age 59½ will mean you owe a 10 percent penalty on the amount you withdraw, as well as taxes on the entire amount you take out. (In tax lingo, these are “non-qualified distributions.”) Let’s say you’re in the 25 percent tax bracket and you pull $10,000 from a traditional IRA. You’d owe $2,500 in taxes plus a $1,000 penalty — a total of $3,500.

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That’s not just an expensive way to get money. Taking an early withdrawal reduces your overall retirement earnings as well. Left in your account for, say, 10 years with a 7 percent return, $10,000 would be worth $19,672. After 20 years at the same rate, you’d be missing out on $38,697.

You can withdraw your principal from a Roth IRA at any time without penalty — and since you’ve already paid the taxes on your contributions, you won’t owe additional taxes. The rules for Roth 401(k)s are different: The IRS assumes you’re withdrawing a prorated amount of principal and earnings, and you’ll pay the penalty and the tax on the amount deemed to be earnings. Say you have $25,000 in your Roth 401(k) — $20,000 in contributions and $5,000 in earnings. Your earnings are 20 percent of your account. If you take an unqualified distribution of $10,000, you’ll owe taxes and penalties on $2,000.

Despite the penalties, more people are taking hardship withdrawals — pulling money from a retirement account early to meet what the IRS terms an “immediate and heavy” financial need — as inflation squeezes household budgets.

Such withdrawals were up 24 percent for the year ending Sept. 30, according to a survey by Empower Retirement, one of the biggest administrators of retirement funds. Another fund company, the Vanguard Group, reported that hardship withdrawals among its account holders hit an all-time monthly high in October. 

How to dodge the 10 percent penalty

There may be times when a financial emergency arises and borrowing money is a mistake, especially given the sharp rise in credit card rates. Thanks to recent legislation, tapping your 401(k) is a bit easier.

Before Congress passed the Consolidated Appropriations Act of 2023 — better known as the omnibus budget bill — you could take early withdrawals from traditional IRAs without getting smacked with the 10 percent penalties for these reasons:

  • You’re making a first-time home purchase. There’s a $10,000 limit on the withdrawal.
  • Higher education expenses for you or your immediate family. That can be tuition, fees and other costs.
  • You have a disability that the IRS considers “total and permanent.”
  • Funeral expenses.    
  • Medical expenses. These must amount to more than 7.5 percent of your adjusted gross income (AGI), which is your gross income minus student loan interest, alimony payments, educator expenses and contributions to retirement accounts.
  • Birth or adoption expenses. The limit is $5,000. The recent SECURE 2.0 bill allows you to repay the withdrawal over three years.
  • Health insurance premiums, if you’re unemployed for at least 12 weeks.
  • You are a reservist or National Guard member and are called up for more than 180 days.

The new tax rules include these additional exceptions to the 10 percent penalty:

  • Emergency withdrawals of $1,000 or less for “necessary personal or family emergency expenses.” Taxpayers have the option to repay the distribution within three years. This won’t be available until 2024, says Mark Luscombe, principal analyst at Wolters Kluwer Tax & Accounting.
  • Domestic abuse victims may withdraw up to $10,000 penalty-free because of physical, psychological, sexual, emotional or economic abuse by a spouse or domestic partner. This won’t be available until 2024.
  • Terminal illness or death. You’ll need a doctor’s certification that you’re expected to die within 84 months (seven years).
  • Qualified disasters. You can make penalty-free withdrawals of up to $22,000 if your principal abode is in the disaster area and sustained an economic loss. This provision took effect immediately but is effective for distributions made after Dec. 31, 2023.
  • Public safety officers who are at least age 50 or have at least 25 years of service.
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It’s always better to have an emergency fund that you can tap when unexpected expenses arise — what certified financial planner Mark Bass from Lubbock, Texas, calls “sleep at night money.” If you don’t have an emergency fund and don’t want to rack up credit card bills, early withdrawal from a retirement plan may be one option to consider. 

That doesn’t mean treating your retirement fund like a piggy bank. “Just because you can take withdrawals doesn’t mean you should,” Bass says.

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