By Steve Dinnen
Every year, Americans pour hundreds of billions of dollars into 401(k) retirement savings plans. And every year, they pay Uncle Sam $6 billion in penalties and fees because they’ve tapped into those accounts too early, at age 59 1/2.
You always have to pay taxes on a 401(k) withdrawal. (In this discussion, we’re also including 403(b) and 457 plans.) But if you’re younger than 59 1/2, you can avoid an early withdrawal penalty if you cite a qualifying reason. Valid reasons can include an expansive range of expenses, such as medical bills, a disability, qualifying higher education, health and insurance premiums, adoption costs and disaster recovery. New this year: Suffering from domestic violence within the past 12 months can also qualify as a reason to withdraw funds early.
Oh — and IRS levies are always a qualifying reason.
But what if none of that works? Well, then try out Rule 72(t). It allows penalty-free withdrawals from retirement accounts but comes with some major restrictions. While avoiding the 10% penalty, you still owe income taxes on distributions. Payments are fixed for at least five years and can’t be changed without a penalty. You lose tax-deferred growth and can’t contribute anymore.
Keith Gredys, who co-founded Kidder Advisers in Urbandale, said he’s seen clients use 72(t) when they’ve accumulated significant funds in their IRAs and are between jobs or need additional income to cover family expenses. Also, sometimes they want to retire before 59 1/2.
The 72(t) exception “has been around for a long time and can be an effective tool for income planning prior to age 59 1/2,” Gredys said. But it’s not used a lot because it’s complex, limited and relatively unknown.
The 72(t) rule mandates that distributions must be a series of equal periodic payments over the life expectancy of the taxpayer or designated beneficiary. You can’t modify the payout (except in cases of death or disability) before the date the taxpayer reaches 59 1/2 or the fifth anniversary of the first payment, whichever comes later.
There are three different ways to get the payout. One is the required minimum distribution (RMD), like the method you would use once you normally begin to take payouts once you clear age 59 1/2. You just make your calculation once per year using the end of the prior year’s balance.
For financial, tax and cash flow planning, Gredys said 72(t) is a great tool when used correctly and monitored.
