401k Withdrawal Rules: Avoid the Penalties, Enjoy the Good Life

401k withdrawal is designed for folks who are at least 59.5 years old. Of course, traditional 401ks involve money you didn’t pay taxes on when it went in, but you will have to pay regular federal and state income taxes on upon withdrawal. (It’s the other way around with Roth 401ks.) In short, your 401k was designed for withdrawal as retirement income when you’ve reached retirement age. Pretty simple.

But what if you really want to tap into your 401k early? Or what if you’re working into your 60s or 70s and plan not to pull from your 401k as early as it was intended? These two scenarios both pose treacherous risks.

Pulling from your 401k early could mean a 10% penalty on anything you take out. Similarly, not taking money out of your 401k after age 70.5 could mean paying a 50% excise tax on what you should have payed.

Let’s take a look at some ways to avoid these fees when retiring early or pulling from your 401k late.

Avoiding 401k Withdrawal Penalties if You Start Too Early

There are only a few circumstances in which you can begin pulling from your 401k early without penalty. Most of them involve serious hardship. The Federal Government doesn’t intend to kick you when you down — at least not when it comes to your 401k withdrawal. Some examples of circumstances when an early 401k withdrawal won’t come with a penalty include:

If you are totally and permanently disabled, and are receiving disability payments from your insurance company or Social Security.
If you just need enough to pay unreimbursed medical bills that amount to at least 7.5% of your adjusted gross income.
If you die and your 401k funds are dispersed to your next of kin, though this isn’t true in all cases.
You are forced to pay up in the event of a divorce and you need to tap your 401k to do so.

But what if you don’t just need a little money to pay a debt or take care of a problem? There’s another way to avoid the 10% penalty for early 401k withdrawal.

Substantially Equal Periodic Payments

Beginning regular 401k withdrawals early without penalty is possible, but it means making a commitment to pull from your 401k monthly or annually for at least 5 years or until you’re 59.5 years old, whichever comes first. (If you’re not ready for that commitment learn more about taking out a 401k loan.)

If you’re retiring early and are ready to pull from your 401k as your income before your Social Security kicks in, or if you are still working but are ready to start pulling from your 401k for the long-haul — say to pay for a retirement house or something similar — this can be a good option.

It’s called taking Substantially Equal Periodic Payments, and if you click that link you can read a whole blog post about how it works.

Each year, millions of Americans pay the 10% penalty for withdrawing their 401ks early. Don’t be one of them. Talk to a Certified Financial Planner or other retirement professional before deciding to tap your 401k early.

Avoiding 401k Withdrawal Penalites if You Wait Too Long

On the other end of the spectrum are those who are still working or who don’t want to tap into their 401ks into their 70s.

If You’re Retired…

If you’re retired, starting 401k withdrawal after you turn 70.5 is required. Waiting longer will more often than not result in that 50% excise tax I mentioned earlier. You must take what is called your “Required Minimum Distribution” by April of the year after you turn 70.5.

Most tax pros recommend starting the same year you turn 70.5 and not waiting until April. This is because you’ll have to take your second by the end of the same year. Taking two Required Minimum Distributions (401k withdrawals) in the same year could put you into a higher tax bracket.

Remember: These 401k withdrawals constitute taxable income. Take too much and you could end up paying disproportionately more in taxes — another kind of withdrawal penalty.

If You are Still Working …

If you are still working after your 70th birthday you can defer your 401k withdrawals, allowing them to grow a little more before you tap in. However as soon as you do retire, you’ll have to begin taking your Required Minimum Distributions by April of the year after your retirement. This is known as the “still working” exception, and it only applies to 401ks. You must begin taking your Required Minimum Distributions from any IRAs you have, even if you’re deferring your 401k withdrawals on the “still working” exception.

Every person’s retirement scenario is unique. And the rules about 401k and IRA withdrawals can be incredibly complex. If you’re considering withdrawal — or weighing it alongside borrowing against your 401k — take the time to sit down with a tax pro, retirement pro or Certified Financial Planner to make sure you aren’t missing anything. Hopefully you found this blog post helpful, but please use it as a starting point, not as the final word on your retirement.

To learn more 401k basics, check out our blog post called 401k Karate: How to Plan for Retirement like a Ninja. It goes farther than anything else you’ll read to make learning about this fun and entertaining. Especially if you like Kung Fu movies.