You've probably heard that if you withdraw taxable amounts from your 401(k) or 403(b) plan before age 59½, you may be socked with a 10% early distribution penalty tax on top of the federal income taxes you'll be required to pay. But did you know that the Internal Revenue Code contains quite a few exceptions that allow you to take penalty-free withdrawals before age 59½?
Sometimes age 59½ is really age 55...or age 50
If you've reached age 55, you can take penalty-free withdrawals from your 401(k) plan after leaving your job if your employment ends during or after the year you reach age 55. This is one of the most important exceptions to the penalty tax.
And if you're a qualified public safety employee, this exception applies after you've reached age 50. You're a qualified public safety employee if you provided police protection, firefighting services, or emergency medical services for a state or municipality, and you separated from service during or after the year you reached age 50.
Be careful though. This exception applies only after you leave employment with the employer that sponsored the plan making the distribution. For example, if you worked for Employer A and quit at age 45, then took a job with Employer B and quit at age 55, only distributions from Employer B's plan would be eligible for this exception. You'll have to wait until age 59½ to take penalty-free withdrawals from Employer A's plan, unless another exception applies.
Think periodic, not lump sums
Another important exception to the penalty tax applies to "substantially equal periodic payments," or SEPPs. This exception also applies only after you've stopped working for the employer that sponsored the plan. To take advantage of this exception, you must withdraw funds from your plan at least annually based on one of three rather complicated IRS-approved distribution methods.
Regardless of which method you choose, you generally can't change or alter the payments for five years or until you reach age 59½, whichever occurs later. If you do modify the payments (for example, by taking amounts smaller or larger than required distributions or none at all), you'll again wind up having to pay the 10% penalty tax on the taxable portion of all your pre-age 59½ SEPP distributions (unless another exception applies).
And more exceptions...
Distributions described below generally won't be subject to the penalty tax even if you're under age 59½ at the time of the payment.
- Distributions from your plan up to the amount of your unreimbursed medical expenses for the year that exceed 10% of your adjusted gross income for that year (You don't have to itemize deductions to use this exception, and the distributions don't have to actually be used to pay those medical expenses.)
- Distributions made as a result of your qualifying disability (This means you must be 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.")
- Certain distributions to qualified military reservists called to active duty
- Distributions made pursuant to a qualified domestic relations order (QDRO)
- Distributions made to your beneficiary after your death, regardless of your beneficiary's age
Keep in mind that the penalty tax applies only to taxable distributions, so tax-free rollovers of retirement assets are not subject to the penalty. Also note that the exceptions applicable to IRAs are similar to, but not identical to, the rules that apply to employer plans.
Need more insight? Let us be your guide.
Our national network of experienced financial advisors can help you create a personalized plan to help you identify financial goals and get you where you want to go in life.Find an Advisor
This information is prepared by an independent third party, Broadridge Investor Communication Solutions, Inc. and is provided for informational and educational purposes only. Waddell & Reed believes the information has been obtained from sources considered to be reliable, but does not guarantee the accuracy of the information provided. This information is not meant to be a complete summary or statement of all available data necessary for making financial or investment decisions and does not constitute a recommendation.
Please note that the information provided may include references to concepts that have legal, accounting and tax implications. It is not to be construed as legal, accounting or tax advice, and is provided as general information to you to assist in understanding the issues discussed. Neither Waddell & Reed, Inc., nor its Financial Advisors give tax, legal, or accounting advice.
This information is not meant as financial or investment advice pertaining to your personal situation. The selection of appropriate investment, insurance or planning options and/or strategies should be made on an individual basis after consultation with appropriate legal, tax and financial advisors. Nothing contained herein is intended as a solicitation or an offer to buy or sell any product or service mentioned and they may not be suitable for all investors. Securities offered through Waddell & Reed, Inc., Member FINRA/SIPC, are not insured by FDIC, NCUA or any other government agency, are not deposits or obligations of the financial institution, are not guaranteed by the financial institution, and are subject to risks, including the possible loss of principal. Insurance products are offered through insurance companies with which Waddell & Reed has sales arrangements. Guarantees provided by insurance products are subject to the claims-paying-ability of the issuing insurance company.