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401K withdrawal strategies for early retirement

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Key Takeaways:

  • Taking money out of a 401K before 59 1/2  is not recommended and can be costly.
  • If you must withdraw money from 401K before retirement – there are steps you can take to not pay the 10% penalty.
  • The CARES Act allows you to withdraw up to $100,000 from your 401K in certain situations.
  • If you want to retire early, there are steps you can take to make your money last a lifetime as well as not pay the 10% penalty. The strategy is outlined below.

Here are 3 ways to take money out of your 401K without paying the 10% penalty.

1. Hardship Withdrawals (where you don’t need to pay 10% withdrawal penalty):

The following are examples of “hardship,” as defined by Congress:

  • Unreimbursed medical expenses for you, your spouse, or dependents
  • Payments necessary to prevent eviction from your home or foreclosure on a mortgage of a principal residence. (Regular mortgage payments do not constitute a hardship.)
  • Funeral or burial expenses for a parent, spouse, child, or another dependent
  • Purchase of a principal residence (down payment) or to pay for certain expenses for the repair of damage to a principal residence
  • Payment of college tuition and related educational costs for the next 12 months for you, your spouse, dependents, or non-dependent children

2. The Cares Act

  • The CARES Act provides for expanded distribution options and favorable tax treatment for withdrawal of up to $100,000 of coronavirus-related distributions from eligible retirement plans (401(k) and 403(b) plans, and IRAs).

Am I a qualified individual for purposes of section 2202 of the CARES Act?

You are a qualified individual if –

  • You are diagnosed with the virus SARS-CoV-2 or with coronavirus disease 2019 (COVID-19) by a test approved by the Centers for Disease Control and Prevention;
  • Your spouse or dependent is diagnosed with SARS-CoV-2 or with COVID-19 by a test approved by the Centers for Disease Control and Prevention;
  • You experience adverse financial consequences as a result of being quarantined, being furloughed or laid off, or having work hours reduced due to SARS-CoV-2 or COVID-19;
  • You experience adverse financial consequences as a result of being unable to work due to lack of child care due to SARS-CoV-2 or COVID-19; or
  • You experience adverse financial consequences as a result of closing or reducing hours of a business that you own or operate due to SARS-CoV-2 or COVID-19.

Do I have to pay the 10% additional tax on a coronavirus-related distribution from my retirement plan or IRA?

  • No, the 10% additional tax on early distributions does not apply to any coronavirus-related distribution.

3. Another option before 59 1/2: Substantially equal periodic payments

  • One option for taking early distributions from a traditional IRA or for taking non-qualified Roth IRA distributions is to use the IRS’s section 72(t)(2) rule.
  • This rule allows retirement account holders to avoid paying the 10 percent penalty by taking a series of substantially equal periodic payments (SEPPs) for five years or until the account holder reaches age 59 1/2, whichever is longer.

The problem with SEPP’s

If payments do not occur for the required amount of time, a penalty of 10 percent is applied retroactively to all of the distributions.

In other words, if you start taking $1,000 a month in SEPPs at age 50 and then at age 54 you stop, you will pay the 10 percent penalty on the $48,000 you’ve withdrawn over the years: a $4,800 penalty, plus interest.

If you’re trying to retire early

If you’re younger than 59 1/2 and trying to retire early, use your non-retirement funds until you reach that age.

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