Secure Your Retirement by Reducing Unnecessary Taxes
An employer sponsored retirement account like a 401(k) is a powerful way to build wealth over the long haul. Despite the 401(k)s popularity, many participants remain mystified about its rules. Unfortunately, this sometimes has negative and unexpected consequences, such as penalties imposed by the IRS, if withdrawals occur before reaching their established retirement age. To maximize your earnings and evade premature erosion in your 401(k), remember these rules for age 59 and after, including when the 401(k) penalty goes into effect.
401(k) Withdrawal Rules Before and After Age 59 and ½
The IRS considers retirement age to be 59 and six months. This is the bare minimum age you must have reached before withdrawals can be taken that are subject only to regular income tax rates, and nothing else. Although regulations are less stringent after reaching retirement age, there are a few caveats worth noting for 401(k) withdrawals made at this time.
The rules after age 59 mainly have to do with making sure some withdrawals occur. The required minimum distribution, established by how much money is in your account and your 401(k) provider, must begin before age 70. This is necessary because the IRS doesn't want individuals using retirement plans like 401(k)s as tax free savings accounts designed to be passed down to their beneficiaries.
Early withdrawals taken before age 59 and one half contain much more stringent rules. For every 401(k) withdrawal made prior to retirement age, the IRS imposes an additional 10% penalty on top of regular Federal income tax rates applied to the income. This is designed to deter retirement savers from pulling money out of the account for purposes besides income during the golden years.
About Early Withdrawal Penalties and Exemptions
The 10% penalty is a harsh blow to any 401(k). In essence, the money simply evaporates into thin air as it goes into government coffers, with no way to recoup it. Remember, this is on top of regular income tax rates that skim money off every 401(k) withdrawal.
Luckily, there are several notable exemptions where the early withdrawal penalty doesn't apply. If you meet financial hardship criteria, you'll be able to see disbursements that are subject only to regular income tax, without the 10% penalties. Providing proof of needing the money to meet basic living expenses, or to avoid a potential eviction or foreclosure is one way to skirt the withdrawal penalty. Similarly, enormous medical debts that amount to more than 7.5% of your annual taxable income qualify you for penalty free early withdrawals.
The 10% penalty doesn't get applied to 401(k) payments made to beneficiaries either. In the event of an unexpected death, the money in the account may be passed down to designated heirs without paying penalties. The funds will still be subject to regular estate taxes, though.
Based on these rules, an early withdrawal for retirement should be used as a last resort, and only when it falls under the exemption criteria to avoid 401(k) withdrawal penalties. With careful attention to IRS imposed requirements and smart strategies for living below your means, you raise your chances of watching your 401(k) grow to its full potential. Books like The Retirement Savings Time Bomb can help you fully navigate taxation in retirement planning. Ultimately, this means more security and funds during retirement, without any worries about breaching regulations before or after age 59.