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Saving for retirement is essential, and while the tax benefits are substantial, what if you need to access your funds right away? There are several ways to tap into your retirement savings, but the many rules can make it overwhelming.
To simplify things, here’s a list of ways you can withdraw funds early, along with the rules and conditions you must consider.
Generally, you can’t (and shouldn’t, if you can avoid it) withdraw from your retirement account before reaching age 59½. If you do, you’ll face a penalty tax of 10% on the amount you withdraw (ouch). There are exceptions, and we’ll highlight them when relevant. (For example, there’s a broad exception for active-duty military personnel, which you can learn more about here.)
Borrow Against Your 401(k)
If you have a 401(k) or 403(b) and need immediate access to funds, most employer-sponsored plans will allow you to borrow from your account. You'll need to pay it back, but it's important to do so in order to rebuild your savings, no matter how you access the money.
There are, of course, limits. You can borrow a maximum of $50,000 or 50% of your account balance, whichever is lower. You’ll have five years to repay the loan, plus interest. The good news is the money, including the interest, goes back into your retirement account. In fact, calling it ‘interest’ is somewhat misleading, since the funds ultimately come back to you.
Since it's a loan, the borrowed funds are not subject to taxes. However, you’ll be taxed on the interest twice: first, because you're paying it with after-tax dollars, and second, because it goes back into your account and will be taxed again when you withdraw it during retirement. Essentially, you're being taxed on money that’s already been taxed.
If you borrow the funds and lose your job before you can repay, your former employer, according to Forbes, will likely require you to repay the loan quickly. If you don’t, they may treat the unpaid balance as an early distribution, meaning you’ll incur penalties.
Request a Hardship Withdrawal
If you anticipate struggling to repay a loan, you may want to consider utilizing the hardship exception available for most 401(k) plans. For your situation to qualify as a hardship, the IRS requires an 'immediate and heavy' need. Here’s what that entails, according to their site:
Expenses that are considered immediate and heavy include: (1) specific medical costs; (2) expenses for buying a primary residence; (3) tuition and other educational costs; (4) payments to avoid eviction or foreclosure on your primary home; (5) funeral or burial costs; and (6) certain repair expenses for damage to your primary residence. Purchases like a boat or television generally don’t qualify for a hardship withdrawal. A financial need can be deemed immediate and heavy even if it was foreseeable or voluntarily incurred by the employee.
If your retirement plan is employer-sponsored, your employer isn’t required to approve this, but most will. The downside, however, is that depending on the hardship, you could be hit with a 10% early withdrawal tax, or penalty, on the withdrawn amount. For instance, you can use your funds for education expenses, but the penalty still applies. This makes the 401(k) loan the more favorable option in most cases.
The IRS offers a useful chart that outlines which hardship situations are exempt from the penalty, based on the specific hardship and type of retirement account.
Hardship withdrawals are also available for IRAs, and they come with even more options that are penalty-free.
Withdraw Your Roth IRA Contributions Anytime
With a Roth IRA, you've already paid taxes on your contributions. We explain this in more detail here, but the reason for this is that it isn’t a tax-deferred account. Unlike a 401(k) or Traditional IRA, the money you save in a Roth IRA isn’t deducted from your taxable income. You pay taxes on it up front.
Because of this, you can withdraw the contributions from your Roth IRA whenever you wish, for any reason. Since you’ve already paid taxes, the IRS doesn’t impose any restrictions. These withdrawals are also penalty-free.
The key here is contributions. Ideally, the money in your IRA grows over time. You cannot withdraw the earnings without penalties, only the actual amount you’ve contributed (or the principal). You’ll need to demonstrate your total contributions over the years, which can be verified by the financial institution holding your account.
In addition to this fundamental rule for Roth accounts, there are specific cases that allow you to withdraw IRA funds without incurring a penalty.
Utilize The Education Exception
You can withdraw funds from your IRA without facing penalties if the money is used for educational expenses for yourself, your spouse, or your children or grandchildren. This applies to any type of IRA, and it’s not limited to just your contributions—you can also withdraw earnings.
However, there are certain guidelines. The IRS is quite clear about what qualifies as an educational expense:
Eligible expenses include tuition, fees, books, supplies, and equipment required for enrollment or attendance at an accredited educational institution. Special needs services for students with disabilities are also covered, as well as room and board for students who are enrolled at least half-time.
Additionally, the institution must be IRS-approved. Thankfully, this typically isn’t an issue, as it includes 'all accredited public, nonprofit, and proprietary (privately owned profit-making) postsecondary institutions,' according to the IRS.
Any funds you withdraw from your account will be taxed if they haven't been taxed already. This applies to all the situations mentioned here.
Take Advantage of the "First Home" Exception
Are you buying your first home? You can withdraw up to $10,000 from your IRA to help cover the costs. If both you and your spouse are first-time homebuyers, you can each pull from your IRAs, giving you a combined $20,000 to put toward the purchase. The rule is quite flexible. You don’t necessarily need to be buying your very first home, just your first 'principal residence.' If you haven’t owned a principal residence at any point in the past two years, you could still qualify. This means that even if you've bought a vacation home, you might be eligible. Additionally, you can use this exception to assist a child, grandchild, or parent.
There are a few conditions. You must use the money within 120 days of withdrawing it. It’s only applicable to principal residences, and can be spent on costs related to purchasing, constructing, reconstructing, financing, or closing on the home.
Since this is a withdrawal, if you have a Traditional IRA, you’ll owe taxes on the amount you take out. Roth IRAs come with their own set of rules for this situation, too.
Specific Roth IRA Rules
Once again, since you’ve already paid taxes on your Roth contributions, it might seem like you don’t need to worry about paying taxes on the money you use for a home purchase. However, when you opened the Roth IRA is important.
If your Roth account has been open for more than five years, it qualifies as a qualified distribution, and you won’t be taxed on the withdrawal for the first-home exception.
But if you opened your Roth IRA less than five years ago, the withdrawal counts as an early distribution. While your contributions won’t be taxed, you may owe taxes on any earnings you withdraw. Bankrate offers a workaround to minimize this tax burden:
You can reduce the taxes by withdrawing your contributions first, since they’ve already been taxed. The IRS has specific rules about the order in which unqualified Roth distributions are taken: contributions, conversions from traditional IRAs, and earnings.
Essentially, if you withdraw your contributions, you should be good to go. If you need additional funds, you can access your earnings, but be prepared for taxes on that amount.
"Reclaim" Your IRA Contribution
Imagine you’re an exceptional saver. You’ve saved so well that you've ended up with a bit more than you intended in your IRA, and now you’re facing a cash shortage.
The IRS offers a provision called a "reclaim" contribution. You can withdraw one contribution made to your traditional IRA without paying taxes on it. However, you must do this before you file taxes for the year, and it’s important to note that you can’t deduct that contribution from your income since you’re essentially taking it back.
If you find yourself in a financial bind and have a traditional IRA, this could be a useful option. Zacks provides further details, with step-by-step instructions on how to execute this process.
Access Funds Through Your Rollover
Here’s a slightly risky workaround if you’re in need of extra cash. You can roll over your Traditional IRA into a Roth IRA and then borrow from that account. The rollover must be completed within 60 days, but you’ll be able to access the funds during this time. If you think you can repay within 60 days, this could be a viable option. However, failing to repay will result in penalties.
Bankrate highlights that this is not a revolving loan. You cannot exploit the system by moving the funds back into your Traditional IRA and then initiating another rollover. The IRS states:
In general, if you make a tax-free rollover of any portion of a distribution from a traditional IRA, you are prohibited from making another tax-free rollover from that same IRA within a one-year period. Additionally, you cannot roll over any amount from the IRA you rolled over into, within the same year.
This might seem obvious, but it’s important to emphasize it.
Consider "Substantially Equal Periodic Payments"
A lesser-known strategy, as noted by Forbes, involves taking "substantially equal periodic payments." The key stipulation is that you must continue these payments for five years or until you turn 59½, whichever is longer. There are a couple of methods to calculate these payments:
The simplest approach, which gives the smallest annual payout, involves dividing your IRA’s total value by your remaining life expectancy. Claudia Hill, president of Tax Mam in Cupertino, Calif., and a Forbes contributor, suggests a reverse strategy. Start by figuring out how much money you need, then determine the IRA size that can provide that annual amount. Afterward, you can split your IRA, allocating just enough to produce the necessary annual payout. If additional funds are needed before reaching age 59 ½, you can withdraw from the second account without disrupting penalty-free distributions from the first.
As always, you’ll be taxed on any funds that haven’t been taxed yet.
Withdrawing from your retirement savings is a major decision and requires careful consideration. Many factors come into play, such as the possibility that, depending on your account type, your withdrawal could increase your adjusted gross income, which might impact your eligibility for financial aid. It’s crucial to weigh all potential consequences before making this decision.
It's also important to think about replenishing your account eventually. Sure, you may need the money you've saved for things like buying a home, paying for education, or covering expenses during difficult times. But keep in mind that you originally saved that money with a specific purpose in mind. Don't lose sight of your retirement goals.
Photos by Nick Criscuolo via Shutterstock, Western Area Power, Christopher Meredith, Tax Credits, Shawn, Kevin Fox, 401(k) 2012, Jonathan Grado, and JR.
