How Can I Avoid 401(k) Early Withdrawal Fees?

If you need to withdraw funds from an individual retirement account or 401(k) account before age 59 1/2, there’s usually a 10% early withdrawal penalty.
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Life doesn’t always go according to plan. Sometimes, even the best financial plan gets a wrinkle, requiring funds to be withdrawn from retirement accounts. This usually comes with both a long-term cost and a penalty. However, a recent article from U.S. News & World Report titled “What is Rule 72(t)?” explains that there’s a work-around.

Rule 72(t) waives the 10% penalty. However, it is only if you take the distributions in a highly specific way. IRS Rule 72(t) allows an early retirement plan withdrawal with no penalty as long as you meet the following qualifications:

  1. All retirement plan-holders must abide by the rules.
  2. All retirement plan withdrawals must adhere to the IRS guidelines.
  3. Plan distribution amounts may not be adjusted for inflation.
  4. Funds withdrawn from traditional retirement accounts are taxable.

What is Rule 72(t)? This rule allows retirement account holders the ability to set up regular withdrawals defined very specifically as substantially equal periodic payments (SEPPS) over the course of five years or until they turn 59 ½, whichever is longer. Most exceptions to the early withdrawal rule penalty require money to be used for a specific qualified, reason. However, funds withdrawn using the 72(t) rule don’t require a specific reason.

Withdrawals for younger people are typically limited to the exceptional events in life, like medical emergencies, college tuition or some economic hardships. However, the 72(t) rule has a strict set of steps where early withdrawals can be taken for any reason, as long as the rules are followed.

How does it work? You may know that you can schedule several SEPP distributions per year. However, in this case, you must take at least one distribution per year for five consecutive years, or until you reach 59 ½ years of age. Once the distributions begin, the payments may not be modified. If a mistake is made and payments are changed, the cost is high—a 10% early withdrawal penalty is imposed retroactively, starting with the first year of distribution.

You may also not use this rule to take distributions from a retirement account associated with a current job. They are not eligible for SEPPS.

Here are further options:

Required Minimum Distributions (RMDs) are calculated annually by dividing the distributable balance by the life expectancy listed on an IRS life expectancy table. The tables are based on a uniform lifetime, single life expectancy or joint and last survivor life expectancy. Your financial planner or estate planning attorney will be able to help you determine which table should be used to get the calculation for your RMD.

Fixed amortization amortizes the distributable balance based on a selected life expectancy table and the IRS-approved interest rate. Once calculated, the annual payment amount stays constant for each successive year.

Fixed annuitization determines payments by dividing the distributable amount alone by the IRS’s published annuity factor applicable to the investor’s current age—or the investors and beneficiary’s current ages. Once the payment method, size and frequency of payments is determined, you are locked into drawing those payments for the next five years or until you reach 59 ½.

Any changes to the payment will result in an expensive 10% penalty – retroactive to all withdrawals.

While this is a good way for younger earners to access retirement money, it doesn’t provide any flexibility and can’t be modified or terminated without hefty penalties.

Reference: U.S. News & World Report (Aug. 23, 2022) “What is Rule 72(t)?”


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