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Taking a Distribution from a Retirement Account? Double-Check Your Strategy

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Unfortunately, retirement plan distributions aren’t all treated the same.  It is easy to mistake subtle rule differences between a 401k and an IRA.  In addition, the rules governing 457b plans, SEP, and SIMPLE IRAs are different too.  This can lead to confusion when taking withdrawals.  For today’s post, we’ll explain the disparity between 401k and IRA distributions.

For both 401k and IRA plans, penalty-free distributions cannot be made until one has reached the age of 59½.  In event of an early withdrawal, a 10% penalty generally applies.  The 10% penalty on early distributions from 401k plans or IRAs is waived in the following situations:

  • Payments are made to a beneficiary due to the death of the account owner
  • Disability
  • Withdrawals up to the amount taxpayers are allowed to deduct from their taxes for medical expenses.  (Note: most individuals are allowed to deduct medical expenses that exceed 10% of their adjusted gross income if they itemize their taxes.  This exception is allowed even for those who don’t itemize, as long as they meet the 10% threshold.)
  • Qualified reservist distribution. (A member of the military not actively serving but who may be called to duty.)
  • IRS levy
  • Made as a series of substantially equal periodic payments. (Similar to an annuity)

Penalty exemptions that are applicable only to 401k plans include those:

  • Made to an employee after separation from service at the age of 55 or later.
  • Made to an alternate payee under a qualified domestic relations order. (Generally from divorce)
  • Made to reduce excess plan contributions by an employee.

A little-known exception exists for employees who separate from employment at age 55.  This rule allows an individual to make a penalty-free withdrawal as long as they separate from service with their employer in the calendar year they turn age 55.  As an example, an employee could leave employment on January 1 at the age of 54, and as long as their 55th birthday occurs by December 31, the distribution will be penalty-free.  Taxes, however, are still applicable for traditional 401k funds.  It is important to note that this exception does not apply if the account is rolled into an IRA first.  Once the IRA rollover is final, the age 55 rule is no longer available.  When leaving an employer between the ages of 55 and 59, consider leaving the funds in the 401k in case a withdrawal becomes necessary.

IRAs have their own set of distribution rules for penalty free withdrawals.  Penalty exceptions applicable to IRAs include distributions made for the following reasons:

  • Qualified higher education expenses.
  • Buying, building, or rebuilding a first home (up to $10,000).
  • Paying for medical insurance premiums due to a period of unemployment.

In most cases, distributions from pre-tax contributions to IRA or 401k plans are subject to ordinary income tax, regardless of the reason for the distribution.  However, the definitional intricacies mentioned above determine whether or not a 10% penalty applies.  Due to the complexity of distribution rules, we recommend consulting with a Certified Financial Planner™ and a qualified tax professional to determine the best course of action for your specific situation prior to taking withdrawals.

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