Here at FutureAdvisor, we’re big proponents of long-term planning. We help clients lay a foundation today that will help them to reach their financial goals down the road, including a sound and secure retirement. However, no matter how much planning anyone does, it’s simply impossible to predict the future. Occasionally, major financial expenses or emergencies come along that may leave you pondering whether or not to dip into your retirement funds.
First things first: it’s important to have a good emergency fund that covers 3-6 months of living expenses. This will help you to avoid taking money from your retirement funds and committing a double-whammy against your savings. Not only does it take your investment principal out of the running, depriving you of further compound interest and future retirement income, but the government often imposes a 10% penalty – that’s in addition to the regular taxes you’ll have to pay on the money – if you make a withdrawal from your 401(k), IRA, or other retirement accounts before you turn 59 ½.
There are, however, some scenarios in which you can dip into your retirement funds without having to pay a penalty. (Keep in mind that you’ll still be on the hook for taxes on that money.)
Here are seven common circumstances under which you can withdraw from your retirement account without paying a penalty:
1. Health Insurance
You can withdraw money from your IRA or 401(k) to pay for health insurance premiums if you’ve been unemployed for 12 consecutive weeks.
2. Medical Expenses
This exemption is for major medical expenses. To qualify, your medical expenses must exceed 7.5% of your gross annual income. For instance, if you make $70,000 a year, your medical expenses must exceed $5,250 during a single year.
3. Take a Loan from Your Workplace 401(k)
You’re allowed to borrow half of your vested balance, or $50,000 (whichever is less), from your 401(k). Although employers aren’t obligated to allow you to take a loan, larger firms typically do. The good news is that you won’t pay a penalty or taxes, and you’ll pay the money back to yourself. The bad news is that if you leave the company, your former employer will probably require that you repay the loan quickly, typically within 60 to 90 days. If you’re unable to do that, your ex-employer will treat the balance of the loan as a regular withdrawal, which means you’ll have to pay taxes and penalties.
4. Layoff or Early Retirement after 55
If you leave your job while you’re between the ages of 55 and 59 ½, you can tap into 401(k) funds from your previous employer’s plan without paying a penalty, although you'll still owe income taxes on the disbursements. You don’t even have to retire permanently; you can go to work for another company. Note that this exemption doesn’t apply to an IRA.
5. Pay For College from Your IRA
If you want to pay for college expenses (e.g., tuition, room and board if the student is in school more than half-time, books, and fees) for yourself, your spouse, children, grandchildren, or other immediate family members, you can withdraw an unlimited amount of money from your pre-tax IRA without paying a penalty. Of course, you will have to pay taxes on the money.
6. Dip into Your IRA For Your First House
You can take up to $10,000 from a pre-tax IRA to buy your first house or a principal residence (only if you haven’t owned a principal residence during the previous two years) without paying a penalty, though you will have to pay taxes on the funds. If you’re married and your spouse is also a first-time homebuyer or hasn’t owned a principal residence for the previous two years, then you can both tap your IRA accounts, giving you $20,000 cash towards a down payment. The IRS also allows you to use funds from your IRA for a down payment for a child, a grandchild, or a parent. Note that this provision does not apply to a 401(k).
7. “Substantially Equal Periodic Payments” from an IRA
You can take distributions in annual equal installments from an IRA at any age, for any reason, without paying an early distribution penalty. You will have to pay income tax, however. Once you begin taking these payments, you have to continue taking them for at least five years or until you’re 59 ½.