Most of our investments are in retirement accounts, such as 401(k) and IRA accounts. We do this to take advantage of the considerable tax-deferral advantage provided by these accounts.
I am often asked if it bothers me to "lock in" our money in such accounts where we won't be able to withdraw the money for many years. Normally money in 401(k) and IRA accounts can be withdrawn only if you are 59½ or more years of age. Any earlier than that, and you have to pay a 10% penalty. I want to explain in this post why this is not a big concern for me, since I am convinced that there are ways to access money early from these accounts penalty-free if it ever becomes necessary.
First, some special cases:
- Most 401(k) providers allow for penalty-free hardship withdrawals in cases of genuine need, such as a medical emergency or disability. This is clearly not a good situation to be in, and shows the importance of having an emergency account and medical and disability insurance. Also, money taken out this way cannot be put back into the retirement account.
- Most 401(k) providers allow short-term loans without penalties. This is again not advisable in most situations. If you leave your job before the loan is paid back, you must pay back the remaining balance. Otherwise it will be considered a withdrawal and subject to taxes and penalties. You also lose the benefit of any growth this money may have had if it had remained invested during the loan period.
- You can withdraw your Roth IRA contributions at any time, without penalty. This does not apply to earnings, just contributions. It is normally not recommended to withdraw funds from a Roth IRA early, due to the unique tax advantages offered by these accounts. It is better to keep the money in the Roth IRA for as long as possible.
There are a number of other options available to early retirees that are quite useful.
- Some 401(k) providers allow early retirees who are at least 55 years old to withdraw as much as they want without the 10% penalty. This option is not available if you quit earlier than 55. Also, this is only available from the employer that you retire from, not from any 401(k) accounts you may have had with your previous employers.
- The most useful option for early retirees to avoid early withdrawal penalties is by taking Substantially Equal Periodic Payments, commonly referred to as SEPP or 72(t) withdrawals. This is only available for IRAs, not for 401(k)'s, so you need to roll over your 401(k) to an IRA before you can do this.
Since the SEPP is the most frequently used option, here are the basic rules, as summarized in a post in My Money Blog:
- You must make the withdrawals regularly, at least once every year.
- You must take them for either 5 years or until you reach age 59 ½, whichever is longer.
- You must wait until these equal payments end before you can start taking unrestricted amounts of money out of your IRAs.
- If you decide to do this, you can’t change your mind. If you do, you’ll owe a 10% penalty retroactive to your first withdrawal, plus interest.
You can calculate the amount of your SEPP according to three IRS-approved methods: required minimum distribution method, the fixed amortization method, or the fixed annuitization method. See the links below for additional details.