How to Pull Your Money Out of an IRA or 401(k) Early and Penalty-Free

Investing money into your IRA or 401(k) is a great way to build wealth and save for retirement. Money goes in pre-tax while earnings grow tax-deferred.

Due to an emergency or unexpected event, you might find yourself short on funds. All of that cash sitting in a 401(k) can certainly look appealing. It can be the answer to your cash flow shortage problem.

Before you pull any money out of your retirement, know the facts and consequences involved. If you are under age 59 1/2, you’ll have to pay a 10% penalty plus federal income taxes (taxed at your marginal tax rate) on the amount you take out. That 10% is the same as throwing money into a flame and watching it burn to a crisp.

“There’s a temptation to access retirement accounts, but it should be an option of last resort,” Mike Loewengart, the vice president of investment strategy at E*TRADE, said to CNBC.

A 2018 study by E*TRADE Financial found that 59% of investors age 18 to 34 made early withdrawals from their retirement accounts. This is up from only 33% in 2015 — a significant increase.

After age 59 1/2, there is no penalty to take money out of your retirement. You’ll still pay taxes though, as early withdrawals are considered taxable income. At age 70 1/2, you are required to begin withdrawals, called required minimum distributions (RMDs).

Investors can be smart about early withdrawals from their retirement account and avoid the 10% penalty. There are a few exceptions to the 10% penalty rule, which we list below. For any of these exceptions, you should consult with a tax advisor to make sure they fall within IRS guidelines.

2020 Coronavirus-Related Exception

With the passing of the CARES act in March 2020, you're now allowed to take out up to $100,000 from an IRA or 401k penalty-free (you still pay taxes, if required).

This applies to "coronavirus-related distributions". For example, if you are diagnosed with COVID-19 or have experienced financial hardship from quarantine, layoffs, reduced hours, or furlough between now and December 31, 2020. It also includes people who are unable to work due to lack of childcare or business owners who can't operate right now.

Since there are tax consequences, the bill also allows the distribution to be claimed on your tax return over three years, so it's not taxed all at once.

Child Birth/Adoption

For tax years 2020 and beyond, distributions of up to $5,000 will be penalty-free if made during the 1-year period beginning on the date on which your child is born or on which you legally adopt an eligible adoptee.

If you are married, each spouse can take the distribution.

This is an update due to the SECURE Act.

401k: Eligible

IRA: Eligible

College Expenses

Death or Disability

Those with disabilities, whether physical or mental, can take early retirement withdrawals without penalty if they are unable to work. A physician will need to verify the severity of the disability.

If the participant of the 401k plan or the IRA owner dies, there will be no penalty on the distributions (but other rules apply to beneficiary accounts).

401k: Eligible

IRA: Eligible

Early Retirement

If you are leaving your job at the same time you turn 55 or older, you can take an early withdrawal from your retirement without penalty. The same is not true if you decide to roll the money over into an IRA. You’ll have to wait until age 59 1/2 to take money out of the Rollover penalty-free.

If you're a public safety employee (law enforcement, firefighter, etc), you are eligible starting at 50. This also includes the Thrift Savings Plan (TSP). 

401k: Eligible

IRA: Eligible

Family Circumstances

A court can require you to provide funds to a divorced spouse, children, or dependents. In those cases, a penalty does not apply for early withdrawals. This is called a Qualified Domestic Relations Order.

401k: Eligible

IRA: No

First-Time Homebuyer

If you are a first-time homebuyer, you can withdraw up to $10,000 ($20,000 for couples) from your IRA. You must not have owned a home in the past two years, and the home you purchase must be your primary residence.

If for some reason the home purchase doesn’t go through, you’ll have to return the retirement money within 120 days from the time of withdrawing to avoid the 10% penalty.

401k: Not eligible

IRA: Eligible

Medical Expenses

Medical expenses that exceed 10% of your adjusted gross income and aren’t covered by health insurance can be withdrawn without paying the 10% penalty. This applies to both a 401k and IRA distributions.

For an IRA specifically, you can also pull out money penalty-free to pay for health insurance premiums if you're unemployed. You must have lost your job and collected unemployment for 12 consecutive weeks. You must also take the distribution in the year you received the unemployment compensation or the following year and before you have been re-employed for 60 days or more. This works for you, your spouse, and your children's health insurance premiums.

401k: Eligible for medical expenses, not for health insurance premiums

IRA: Eligible

Military Service

Military reservists who are called to active duty for more than 179 days do not have to pay a penalty for early retirement withdrawals.

However, this is another area we don't recommend.

401k: Eligible 

IRA: Eligible

Substantially Equal Periodic Payments (72t Payments)

You can take regular withdrawals from your IRA without penalty by using it as an annuity. Withdrawals are based on life expectancy. Life expectancy is calculated by a professional. Withdrawals are taken at least annually. If at any time you don’t withdraw the right amount, penalties may be applied.

You must continue this plan for at least 5 years, or until you reach age 59 1/2. 

There are three ways to calculate your SEPP payments:

1. Required Minimum Distribution: The IRS has full guidance on RMD by age.
2. Amortization: You calculate an annual withdraw schedule the conforms to some rules set by the IRS.
3. Annuitization: You create an annuity payment based on the IRS mortality table.

This is a popular way to access your accounts early.

401k: Eligible 

IRA: Eligible

Roth IRA 5 Year Rules

The Roth IRA has a unique set of rules called the "5 year rule" that allows for potentially withdrawing contributions tax and penalty free. One rule applies specifically to contributions and one applies to conversions. 

5 Year Contribution Rule: This rule determines whether earnings will be tax-free. You must have had the funds in the IRS for at least 5 years for your earnings to be tax free. 

5 Year Conversion Rule: This rule determines whether the conversion can be withdrawn penalty free. It's similar to the contribution rule, but this applies to money that was converted to a Roth IRA (say, from a 401k or traditional IRA). Each rollover/conversion you make is subject to a separate 5 year rule.

It's this second rule (the 5 year conversion rule) that many early retirement folks use when planning on how to access their retirement funds early. The Mad Fientist has a great explanation of this here. 

Note: Roth distributions come from principal first, then earnings. So, even a distribution of less than 5 years can have no tax implications if there are no earnings (for example, in the case of a loss). 

Alternatives to Early Withdrawals

401(k) Loan

Whether you can take out a loan against your 401(k) is up to your employer. Some allow this, and some don’t. Loans can be taken out for five years or longer. Interest accrues to yourself and must be paid back with the loan.

If you have a solo 401k, you can setup your own loan rules when you create your plan. We break down which providers allow 401k loans here: Comparing The Best Solo 401k Plans.

Rollover

If you recently left your employer and have an old 401k plan just sitting there, you don't need to take a withdrawal or distribution. You can, instead, roll it over to an IRA and continue to watch it grow until retirement. This is usually the smart move for most people.

Check out this guide to finding the best Traditional or IRA accounts so you can invest your money wisely.

Taking The Distribution

Finally, you can just take the distribution and pay the penalty. This isn't the best idea compared to the alternatives, but in some cases, it could make sense.

Just remember, you're going to pay ordinary income tax, state taxes (depending on the state), and the extra 10% penalty on your money.

Depending on your income tax bracket, this could be a substantial amount of taxes!

For example, let's say you're married, living in California, and already making $100,000 per year. You want to take $50,000 out of your 401k. That would put you in the 22% Federal tax bracket. It would also put you in the 9.3% state tax bracket. Then you would pay the 10% penalty on the $50,000 as well. So, you're going to pay 41.3% in taxes on that early withdrawal - making your $50,000 only worth $29,350.