Saving for retirement is an important financial goal, but many people struggle with it. Some are concerned that it means locking up funds and making them inaccessible for other financial goals. But this, in fact, is a myth.
For example, a young 28-year-old entrepreneur once asked me if she could use some of these funds towards down payment for her first home. A 40-year old mid-career professional wondered if he could use any of his retirement money for college costs for his children. And a 56-year old individual, who lost his job recently, asked if he could withdraw from his 401(k) without penalty for living expenses.
The truth of the matter is that each of the people in the above situations could use their retirement funds to some extent, without having to pay penalties.
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Let us look at four scenarios where money in your retirement fund is available to you penalty-free:
1. Roth IRA Contributions
You already paid taxes on your Roth IRA contributions. So, you are free to withdraw this money anytime tax-free, and penalty-free. Yes, even one day after you contributed! In fact, for this reason, Roth IRA contributions can be considered not only retirement savings, but also as a means to fund your emergency needs.
However, one word of caution: The tax-free, penalty-free rule applies only to your contributions, not to the earnings generated from your investment.
For example, say you contributed $5,500 each year for the last three years to your Roth IRA. Let us further say, thanks to your investment savviness, your Roth account grew to $20,000. Any withdrawals up to $16,500 incur no taxes or penalties. On the other hand, if you withdraw the entire $20,000, $16,500 will come out tax- and penalty-free, but you will have to pay taxes on the $3,500 of earnings. And finally, based on rules as defined in by the IRS in publication 590a, you may have to pay a 10% penalty on the $3,500.
It is your responsibility to keep track of the contributions versus growth in your account balance.
2. 401(k) Loans
If your employer-sponsored plan allows, you could borrow up to 50% of your account balance or $50,000 (whichever is less) from your 401(k) for any reason. Yes, that is true – for any reason! The money goes into your pocket with no taxes and no penalties. Moreover, the process of getting the cash in your hand could be much simpler than it is using the traditional routes of borrowing from a lender such as a bank.
That said, you need to weigh your options carefully and figure out whether a 401(k) loan is indeed an optimal financial decision for your unique situation. There are several factors to consider:
- You are required to pay back the loan with interest as per the stipulated rules of the plan.
- If you leave the employer while the loan is still outstanding, you are typically given 60 days to pay the balance. If you fail to pay within the time frame, your balance could be considered an early distribution from your 401(k), and you may be forced to pay taxes and penalties on the outstanding balance.
- The funds you pull out of your 401(k) are no longer participating in the tax-deferred growth, and thus, you may be losing on such opportunity.
3. Traditional IRA Funds in Special Circumstances
Generally speaking, you will pay a hefty 10% penalty for taking a distribution from your IRA account before age 59½, in addition to the taxes you owe. For example, if a hypothetical 40-year old individual in the 25% tax bracket takes $10,000 from his IRA account, he will have to pay $1,000 in penalties and $2,500 in taxes.
However, the IRS offers exceptions to this rule that allow you to take a distribution without penalty. Note, though, that you still pay taxes on the money you withdraw; you only avoid paying the penalty. Here are some such special circumstances:
- purchasing of your first home (up to $10,000);
- paying higher education costs for yourself, spouse, children or grandchildren;
- covering your medical expenses that exceed a threshold amount;
- and covering financial hardships due to disability.
Find the full list of exceptions in IRS Publication 590B.
4. 401(k) Funds for People Age 55 or Older and Separated from Their Jobs
With respect to the funds in an employer-sponsored 401(k) plan, there is a unique situation where you could withdraw funds before age 59½ yet pay no penalty—when you are age 55 or over and "separated from service" from the employer. For example, a 56-year old individual who retired, quit or got laid off is eligible for such a penalty-free withdrawal from his 401(k).
The key here is that the separation from service should be in the year you turn 55 or later. In other words, if you are separated from service at the age of 52, you cannot wait until age 55, take a distribution from your 401(k) and expect the distribution to be penalty-free.
A couple of additional points to note:
- You still pay income taxes on the distribution, and
- this exception applies to balances in your 401(k) only, not in your IRAs. In other words, if you rolled over your 401(k) to an IRA, and you take a distribution from the IRA before you reach age 59½, you do pay a 10% penalty on the money you withdraw.
So, what do you think? Does knowing that the money you save for retirement is your money, and you have full access to it, make you feel more comfortable putting money away? After all, saving for retirement is an important financial goal. Start saving today and enjoy the tax benefits that come along with it. Good luck!
Vid Ponnapalli is the founder and president of Unique Financial Advisors. He provides customized financial planning and investment management solutions for young families with children and for professionals who are approaching retirement. He is a Certified Financial Planner™ with an M.S. in Personal Financial Planning.