The Savings Game: Penalty-free withdrawals from retirement plans

Once you establish a retirement account, such as an IRA or 401(k), you want to maintain your balances and obtain tax-free growth for as long as possible. When unplanned expenses arise, you don’t want to make withdrawals from your retirement accounts unless there are no other viable options.

If you do have to withdraw funds from your retirement plans, you need to know how to do so without incurring penalties.

There are now over 20 exceptions to the 10% penalty. Ed Slott, a retirement plan expert, believes that “early withdrawals from retirement accounts should be discouraged because they reverse the retirement savings process, and early distributions are the most expensive. They are highly inefficient as they can be subject to both income tax and the 10 percent early withdrawal penalty, which combined can erode half of the distribution. It would be better to take the necessary cash from a non-taxable account.”

There are three categories of early withdrawal exceptions: exceptions that apply to both qualified company plans and IRAs; exceptions that apply only to IRAs; and exceptions that apply only to company plans.

Exceptions to both IRAs and company plans include: death; disability; rollovers; annuitizing (rule 72(t) substantially equal periodic payments); medical expenses (over a threshold of 7.5% of adjusted gross income); IRS levy; reservists called to active duty; birth or adoption (limit: $5,000 per child); terminal illness; federally declared disasters (limit: $22,000); domestic abuse (limit: lesser of $10,000 or 50% of account); and emergence expenses ($1,000).

Exceptions for IRAs only (including SEP and SIMPLE IRAs) include: higher education expenses; first time home buyer ($10,000); and health insurance (if you are unemployed).

Exceptions for company plans only include: separation from service (age 55, or age 50 or 20 years of service for public safety employees); section 457(b) governmental plans; divorce (under a Qualified Domestic Relations Order); phased retirement distributions from federal plans and pension-linked savings accounts.

Additional information
Death: If you inherit an IRA as a beneficiary, even if you have not reached 59 1/2, you are not subject to a 10% early withdrawal penalty on withdrawals; unless the account was a Roth IRA or Roth 401(k), you would be subject to income taxes.

Disability: There is no 10% early withdrawal penalty if you are categorized as “unable to engage in any substantial gainful activity by reason of a medically determinable physical or mental impairment which can be expected to result in death or to be of long-continued and indefinite duration.”

Medical expenses: Penalty-free early withdrawals can be made if the funds are used to pay unreimbursed medical expenses exceeding 7.5% of your adjusted gross income (AGI).

Annuitizing: This is referred to as the “72(t)” exception. It allows you to escape the early withdrawal penalty by taking your yearly contributions in substantially equal periodic payments for five years. This option is not flexible however, and is subject to penalties if you don’t take the same required distribution for the five-year period. For this option, I recommend the use of a certified financial planner.

401(k) loans: Some employers allow individuals to borrow funds from their 401(k). However, the funds must be repaid within five years. If an individual with an outstanding loan leaves the company within five years, the amount outstanding would be considered a withdrawal and be subject to tax (unless it’s a Roth 401(k) and would be subject to a 10% early withdrawal penalty if the borrower has not reached 59 1/2.

Advantages of Roth accounts: If you have a Roth IRA or Roth 401(k), regardless of your age, you are allowed to make withdrawals of your contributions without penalty. Because you have already paid the income tax when you made the initial contribution, there would not be any income tax due on your withdrawal. You should avoid withdrawing earnings if you have not reached 59 1/2, because then you would be subject to a 10% withdrawal penalty.

Good source: An excellent source of information on IRA exceptions is IRS Publication 590-B.

Social Security Fairness Act update
Starting the week of February 24, the Social Security Administration will begin retroactive payments and will increase monthly benefit payments to people whose benefit had been affected by the Windfall Elimination Provision (WEP) and Government Pension Offset (GPO).

Affected beneficiaries will receive a one-time retroactive payment, deposited into the bank account SSA has on file, by the end of March. This retroactive payment will cover the increase in their benefit amount back to January 2024, the month when WEP and GPO no longer apply under the Social Security Fairness Act.

As most Social Security benefits are paid one month behind, affected beneficiaries will begin receiving their new monthly benefit amount in April 2025 (for their March 2025 benefit).

Anyone whose monthly benefit is adjusted, or who will get a retroactive payment, will be notified by mail by the SSA explaining the benefit change or retroactive payment. They may receive the retroactive payment before receiving the mailed notice.

The SSA urges beneficiaries to wait until April to inquire about the status of their retroactive payment, and to wait until after receiving their April payment before contacting SSA to ask about their monthly benefit amount.

(Elliot Raphaelson welcomes your questions and comments at raphelliot@gmail.com.)