How To Tap Retirement Funds Penalty-Free - 401K Advice and Retirement

How To Tap Retirement Funds Penalty-Free
April 7, 2009
Janet Novack
Forbes.com

In a pinch, you may be able to get your money early, but watch out for traps.

Congress, in its wisdom, has created more than a dozen different tax-advantaged retirement savings accounts, each with its own confusing rules on contributions, distributions and--even more pertinent these days--withdrawals before retirement.

Consider the case of a 55-year-old Texan who needed cash to pay medical and other expenses. He knew distributions from a 401(k) taken before age 59 1/2 are often subject to a 10% penalty, in addition to the normal tax. In fact, in 2006, an estimated 5.1 million taxpayers got stuck paying that 10%.

But after reading the rules, the Texan concluded he qualified for two of the many exceptions to the penalty--one for money used for certain medical bills and another for those who are 55 and retired from or have otherwise left the job associated with the 401(k). So he took $23,500 from his 401(k) and reported on his tax return that no penalties were due.
In Pictures: 10 Ways To Tap Retirement Cash Early

The Internal Revenue Service, however, slapped him with a $729 penalty on the $7,290 he hadn't used for medical bills and last year the U.S. Tax Court upheld that penalty. Why? He'd left the job at 53 and the penalty-pass for 55 year olds only applies to those who are at least 55 in the year in which they hang it up-- except that "qualified public safety employees" only have to stay on the job until 50. Moreover, the 55-year-old exception doesn't apply to an individual retirement account, even if the money in that IRA was rolled there from the 401(k) of a worker who left the job after 55.

Got all that?

Or, suppose you've been in an accident, have been laid up for six months and are desperate for cash to pay the mortgage. Your employer might allow you to take a "hardship" distribution from your 401(k) for living expenses, but unless you're permanently disabled, it will be subject to a 10% penalty, as well as ordinary tax. Similarly, you can tap your pre-tax IRA at your own discretion, but "financial hardship" won't get you out of a 10% penalty in that case either. Yet if you're a state or local worker with a 457(b) savings plan, instead of a 401(k), you can take a hardship payout without owing a penalty.

Differing rules such as those, IRS Taxpayer Advocate Nina Olson told Congress recently, can seem "impenetrable to taxpayers and grossly unfair."

Still, there are ways to avoid penalties, and one of them might just work for you.

One common method is to borrow from your own 401(k). The law allows you to borrow up to $50,000 or half your vested balance, whichever is less, and to take up to five years to pay the money back. Employers don't have to offer loans, but most big firms do. As with most techniques, there's also a potential trap: If you leave or lose your job, your ex-employer will likely demand quick repayment and if you can't repay, treat the outstanding balance as an early distribution, subject to interest and penalties.

Another less well-known option: You can avoid the withdrawal penalty at any age, and for any reason, by beginning "substantially equal periodic payments" from an IRA. The catch here is you must continue taking these payments for five years or until you are 59 1/2, whichever comes later--even if you no longer need the cash.

Incredibly, there are three possible ways to calculate the periodic payout. With the simplest (which produces the smallest annual payout) you divide the IRA's total value by your remaining life expectancy. Claudia Hill, president of Tax Mam, in Cupertino, Calif., recommends you work backwards. First, figure out how much cash you need and then calculate out how big an IRA will produce that annual distribution. Then, split your IRA, with one piece holding just the amount needed to produce your desired annual payout. Later, if you need still more cash before 59 1/2, you can draw it from the second account, without jeopardizing penalty-free distributions from the first.

Other penalty exceptions sound simpleÂr, yet still harbor traps. For example, you can take money for higher-education expenses penalty free from an IRA, but not from a 401(k). That means that if you leave a job to attend graduate school, you must first roll the money from your 401(k) into an IRA before using it for tuition.

Watch out, too, for timing traps. You can take a penalty-free distribution from either a 401(k) or an IRA to cover out-of-pocket medical expenses that exceed 7.5% of your adjusted gross income. But those expenses must be paid in the same year you take the distribution. An Ohio couple learned this the hard way. After borrowing money from a credit union to pay for infertility treatment in one year, they withdrew $16,250 from a 401(k) the next year to pay off the loan. In November, a U.S. Tax Court judge expressed sympathy for the couple--before he upheld an IRS-imposed $1,625 early withdrawal penalty.

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