Retirement accounts offer a lot of great benefits for savers, but they have their limitations as well. In order to put yours to work for you, you need to understand their rules. Failing to do so could result in steep penalties.
There's one mistake that's proven especially costly for Americans in recent years. Below, we'll talk about what it is and how you can avoid it.
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Remember, you're locking your money away
Retirement accounts are intended for long-term savings, and the government discourages workers from making early withdrawals by instituting a 10% penalty for funds withdrawn before age 59 1/2. This applies to most retirement accounts, including 401(k)s.
Yet more than half of Americans have taken an early 401(k) withdrawal and paid the price. Recent research by Capitalize estimates that it cost people a whopping $6.12 billion in 2023 alone. And that's just the penalties. It doesn't include the income taxes these workers will have to pay on their withdrawals.
Some might feel the penalty is worth it, especially if they're in a tight financial spot and have no other obvious means of obtaining cash. But there might be some ways for you to get the money you need and avoid the extra fees. It comes back to knowing the rules of your account.
3 ways to avoid early withdrawal penalties
Here are three ways you may be able to avoid early withdrawal penalties:
1. Withdraw money for a qualifying exception
The IRS allows you to make early 401(k) withdrawals without penalty for several reasons, including:
- To cover birth or adoption expenses
- If you become permanently and totally disabled
- If you're the victim of domestic abuse
- To pay for qualifying higher education expenses
- To cover large, unreimbursed medical expenses
- If you develop a terminal illness
Other types of retirement accounts, like IRAs, have similar exceptions. But 401(k)s have some exceptions that IRAs don't, and vice versa. Reviewing your options and withdrawing from the right account could help you avoid early withdrawal penalties.
2. Consider using Roth IRA funds if you've got them
Roth IRAs allow you to withdraw your personal contributions penalty-free if you've had the account for at least five years. However, you could still face penalties if you withdraw your earnings before age 59 1/2.
This rule doesn't apply to 401(k)s or Roth 401(k)s, but you may be able to get around that by doing a Roth IRA conversion or rollover. If you have an old Roth 401(k) from your previous employer, you can roll that into a Roth IRA and begin withdrawing your contributions, assuming the money has been in a Roth account for at least five years.
Or you can convert your tax-deferred savings from a traditional 401(k) into a Roth IRA. But to do this, you must pay taxes on the converted sum in the year you make it. And you need to wait five years from Jan. 1 of the year you made the conversion (until Jan. 1, 2029 for conversions made this year) to withdraw your funds. But this could still work if you're trying to set yourself up to cover a major expense in five years or so.
3. Make Substantially Equal Periodic Payments (SEPPs)
Substantially Equal Periodic Payments (SEPPs) are a strategy often used by those who retire early to enable them to access their 401(k) funds without penalty. It requires you to make annual withdrawals of a certain amount for the longer of five years or until you turn 59 1/2.
There are a few ways to calculate how much you need to withdraw, so you may want to consult with a financial advisor to figure out which method is best for you or whether SEPPs are your best option at all.
Avoid early withdrawals if at all possible
Sometimes, early withdrawals can't be avoided. But whenever possible, it's best to cover your costs another way. Even if you manage to skip the early withdrawal penalties, you could still owe taxes on the withdrawal, and you'll be shrinking your nest egg.
If you wind up taking an early retirement account withdrawal, make sure you rethink your retirement strategy going forward. You may have to delay retirement or increase your monthly savings rate to get back on track again.
