If you have money in a traditional employer-sponsored retirement plan, such as a 401(k) or 403(b), you are probably aware that withdrawals before age 59½ generally are not advised. Early withdrawals are allowed under certain circumstances, but in most cases they are subject to a 10% penalty — on top of ordinary income taxes. However, if you need to tap 401(k) funds early, it is possible to avoid penalties (not taxes) in limited situations.

Hardship withdrawals

Before you attempt to take early withdrawals from your retirement account, be sure you understand the terms of your plan. Just because the IRS allows certain types of withdrawals does not mean your plan does. Also, even if your plan allows early withdrawals under certain circumstances, that does not mean those withdrawals are penalty-free. Whether an early withdrawal is permitted and whether it is subject to the 10% penalty are two separate questions.

If permitted by your plan, the IRS allows hardship withdrawals if you have “an immediate and heavy financial need” and the amount withdrawn is “necessary to satisfy that need.” Some types of financial need are deemed to meet this standard, including:

• Certain medical expenses;
• Costs associated with the purchase of a primary residence;
• College tuition and related educational expenses;
• Certain expenses for the repair of damages to a primary residence; and
• Payments necessary to prevent eviction from, or foreclosure on, a primary residence.

Most of these hardship withdrawals are still subject to the 10% penalty. However, you may escape penalties if you withdraw funds for unreimbursed medical expenses that would be deductible as itemized deductions (currently, they must exceed 7.5% of your adjusted gross income). Note that the rules for IRAs are different. For example, you can withdraw IRA funds penalty-free for certain first-time homebuyer and educational expenses.

Related Read: Proposed IRS Regulations Liberalize Rules for Hardship Withdrawals

Rule of 55

If you are retiring early, lose your job or are changing jobs, the Rule of 55 may allow you to tap your 401(k) funds penalty-free. To qualify, you will need to meet several requirements. The first is that you leave your job during or after the year you turn age 55 (age 50 for certain public safety workers). Your employer’s plan also must allow Rule of 55 withdrawals. Finally, you must withdraw funds from your most recent employer’s 401(k) plan. The rule does not apply to funds in previous employers’ 401(k) plans.

Bear in mind that you will still owe income taxes on Rule of 55 withdrawals. In addition, some plans require you to take a lump-sum withdrawal of your entire account balance, which can have negative tax consequences.

Periodic payments

You can avoid penalties on early withdrawals at any age by using a series of substantially equal periodic payments (SOSEPP) over your life expectancy or the joint life expectancies of you and your designated beneficiary. For a 401(k) or similar employer plan, your plan must permit SOSEPP payments and you must leave your job before the payments begin.

There are three methods available to calculate the payment amount:

1. At the end of each year you divide your account balance by your life expectancy (or the joint life expectancies of you and your beneficiary) according to IRS tables;
2. You amortize your initial account balance over a set period of years based on the appropriate life expectancy tables and a “reasonable” rate of interest; or
3. You divide your initial account balance by an annuity factor derived from an IRS-prescribed mortality table and use a reasonable interest rate.

Earlier this year, the IRS revised its guidelines about what constitutes a reasonable interest rate. As a result, 401(k) plan participants may be able to withdraw larger SOSEPP payments (see “Making SOSEPPs more attractive” below).

Other exceptions

There are several other circumstances under which early distributions from a 401(k) plan may avoid the 10% penalty. They include distributions on account of death or disability, divorce-related transfers according to a qualified domestic relations order, distributions to satisfy an IRS tax levy and withdrawals of up to $5,000 per parent following the birth or adoption of a child.

Whatever your reason for wanting to take an early withdrawal, talk with your advisors first to discuss the tax implications. Although certain withdrawals may be taken penalty-free, they are still subject to ordinary income taxes and, depending on the size of the withdrawal, can even push you into a higher tax bracket. Also consider the opportunity cost of an early withdrawal: the loss of future tax-deferred growth. If, for example, you withdraw $50,000 at age 55, your balance will be nearly $100,000 smaller at age 65 (assuming your account earns a 7% annual return). So consider retirement plan withdrawals only as a last resort.

Related Read: Reduce Plan Leakage by Upgrading Your 401(k) Loan Rules and Practices

Sidebar: Making SOSEPPs more attractive

In January 2022, the IRS revised its guidelines for determining a “reasonable” interest rate to calculate payment amounts under the series of substantially equal periodic payments (SOSEPP) exception to the 10% penalty on early retirement account withdrawals. Previously, to be reasonable, interest could not exceed 120% of the applicable federal mid-term rate (around 3.7% at the time of writing). Now, you may use that figure or 5%, whichever is higher. Using a higher interest rate when calculating the payment amount under the amortization or annuitization methods allows you to withdraw larger amounts without triggering financial penalties.

SECURE Act 2.0: Emergency Withdrawals

The SECURE 2.0 Act of 2022 includes several provisions allowing defined contribution plan participants to access a portion of their retirement savings with no 10% early withdrawal penalty in certain situations.  Plan sponsors may offer penalty-free distributions to participants who were affected by major disasters, have experienced domestic abuse, have personal emergency expenses or have a terminal illness.

SECURE 2.0 includes a separate provision that allows plan sponsors to offer non-highly compensated employees an emergency savings account linked to their retirement plan account.  Participants experiencing an emergency can withdraw their entire savings account balance, which is limited to $2,500 without penalty.

For more information, contact Jeffrey R. Green at [email protected] or 312.670.7444. Visit ORBA.com to learn more about our Wealth Management Services.