Early Retirement Withdrawals? Is it Worth it?

It’s common for clients save for retirement throughout their entire working career.  Individuals who are fortunate enough may spend decades contributing to their IRAs and 401(k)s.  The need to access retirement savings for one reason or another is also extremely common even well before the client has reached retirement age.  Life is unpredictable and expenses can pile up—especially in the wake of a busy holiday season.  However, early access to retirement funds is limited and can also quickly become expensive.  It’s critical that clients who are considering tapping their retirement savings before reaching age 59 ½ understand the IRS rules on early withdrawals—and the significant penalties that can apply for both early IRA and 401(k) withdrawals.

Early Withdrawal Penalties: Basic Rules

Most clients know the basic rules governing retirement plan withdrawals.  Taxpayers are entitled to contribute a limited amount of pre-tax dollars to their 401(k)s and IRAs each year, thereby reducing tax liability.  To encourage those individuals to save the funds until retirement, a 10% early withdrawal penalty applies if the client starts withdrawing funds before reaching age 59 ½.

IRA owners can take distributions from their IRAs at any point, and for any reason.  However, if an exception doesn’t apply and the taxpayer isn’t 59 ½, the 10% early withdrawal penalty is tacked on to the ordinary income tax liability that any retirement withdrawal generates (of course, Roth accounts are subject to different rules).

Clients can only take distributions from 401(k) accounts when certain events occur.  For clients who have yet to reach age 59 ½, it’s critical to determine whether an exception applies.

Traditional exceptions to the early withdrawal penalty include (1) disability, (2) reaching age 59 ½, (3) to cover certain unreimbursed medical expenses, (4) separation from service after reaching age 55 (for employer-sponsored plans), (5) distributions that satisfy the “series of substantially equal periodic payments (SEPP)” rules or (6) death.

Hardship distributions provide another way for 401(k) participants to access their retirement funds.  The terms of the specific plan will govern the types of distributions that are permitted.  In the most general terms, participants can take a hardship distribution to cover “an immediate and heavy financial need”.  The amount of the distribution can only cover the amount of the need.  While the need can be created because of financial liabilities that were incurred voluntarily, consumer purchases generally don’t quality.  While hardship distribution may be permitted, they also may be subject to the 10% early withdrawal tax unless a specific exception applies.  Note that hardship distributions cannot be repaid.

Qualified plans can also permit a participant to take a non-taxable loan. If the participant repays the loan according to the terms of their agreement, the loan will not generate taxes and penalties.

New and Less Common Exceptions to the Early Withdrawal Penalty

For tax years beginning in 2024 or later, the SECURE Act 2.0 allows 401(k) and IRA participants to take emergency distributions from their retirement savings accounts without penalty.  These emergency distributions are limited to $1,000 each year.  Also, taxpayers who take emergency distributions can repay the distribution within a three-year period (otherwise, they will be prohibited from taking another $1,000 distribution during the following three-year period).

The IRS also often allows repayable distributions for taxpayers who are dealing with the aftermath of federally declared national disasters.  The SECURE Act 2.0 created new provisions to allow penalty-free distributions to cover up to $2,500 in long-term care insurance premiums this year.  Taxpayers who are dealing with the cost of a qualified birth or adoption can also access up to $5,000 in penalty-free withdrawals (which can be repaid within a three-year period).

Some exceptions only apply to IRAs.  Taxpayers who have yet to reach age 59 ½ may be able to tap their IRA savings without penalty to cover the costs of higher education.  This penalty-free withdrawal option is only available to IRA owners (not participants in company-sponsored plans, such as 401(k)s).  Qualifying education expenses include things like tuition, fees, books, etc.

IRA owners can make penalty-free withdrawals for purchasing a first home (this penalty exception is limited to IRA withdrawals of $10,000 or less).

Conclusion

Clients should be advised that even when an exception to the withdrawal penalty applies, the distribution will still constitute taxable income.  The retirement plan will send the client a Form 1099-R upon distribution.  Clients who are taking an early distribution should use Form 5329 to report the distribution and either report the amount of the 10% penalty or claim an exception.

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