One of the key decisions when leaving an employer is what to do with your 401(k) from your old company.
Often the wisest choices are to leave it with your old employer if their plan is a solid one; roll it over to a new employer’s plan if this is applicable, if they allow it and if their plan is a solid one; or roll the balance to an IRA account. Taking a withdrawal is generally discouraged, due to the tax liability and the fact that those who are under age 59½ are generally subject to a 10% penalty on top of the taxes owed.
There are several situations that allow you to withdraw money from your 401(k) plan prior to age 59½ without incurring the 10% penalty. Please remember income taxes will still apply. These situations include:
- To cover medical expenses in excess of 7.5% of your adjusted gross income.
- In the event of a Qualified Domestic Relations Order, where the court mandates that all or a portion of your account goes to a former spouse, a dependent or a child.
- You become disabled or die (your beneficiary then gets the money).
- Certain distributions to qualified military reservists.
- Distributions due to an IRS levy.
- If you change your mind regarding contributions made under special auto-enroll rules.
If any of these apply to you, your best course of action is to contact the benefits department at the company.
There are two others we will now discuss in some detail.
- Using the 72(t) rules to take a series of substantially equal distributions.
- Separating from service at age 55 or older.
Both of these techniques are tactics to consider if your desire is to withdraw funds from your 401(k) account prior to age 59½ while avoiding the 10% penalty.
72(t) Distributions: Substantially Equal Payments
The 72(t) rules allow for substantially equal withdrawals from a retirement account, such as a 401(k) or an IRA, over a period of time without incurring an early withdrawal penalty.
Substantially equal payments are based upon your life expectancy and must last at least five years or until your reach age 59½, whichever is longer, once they commence.
Depending upon your employer’s plan document, you may or may not be able to take a 72(t) withdrawal from your 401(k). If you are still employed, you will need to consult your plan’s rules including those for early in-service withdrawals.
In the case of a 401(k) from an old employer, the in-service rules don’t apply, but you will still need to ask the administrator if they will do 72(t) withdrawals for you.
If the answer is no, then you might be forced to roll this 401(k) balance over to an IRA and take the distributions from that account.
The rules surrounding 72(t) withdrawals are very complex, and frankly, many IRA custodians are not fully informed on the rules or the process. This is likely the case with some 401(k) administrators as well.
If you want to go this route it might behoove you to find a tax professional who understands the rules. Getting the process wrong, such as missing a distribution, can be costly. This could result in what is called a “modification,” and the 10% penalty would then apply not only to that distribution but also retroactively to all prior distributions.
Another thing to take into consideration is the fact that taking these distributions early will result in less being available for you at retirement. While everyone’s situation is different, this is a factor to consider before going this route.
Separating From Service at Age 55 or Older
An exception to having to pay a penalty for withdrawals prior to age 59½ occurs when you separate from service with your employer at age 55 or older. This can be for virtually any reason, including retirement, quitting or getting fired.
Three key points to keep in mind here:
- This applies if you leave your job at any time during the calendar year in which you turn 55 years old or later.
- This exception applies only to funds withdrawn from a 401(k). The rules for an IRA are different. If you roll your 401(k) into an IRA account prior to age 59½ you will lose this exception.
- This also wouldn’t apply to any funds left in a 401(k) account with a former employer if you left that employer prior to age 55. If you know you will be leaving your current employer at 55 or later, but prior to age 59½, you should consider rolling these old account balances into the 401(k) of your current employer if part of your strategy is to make penalty-free withdrawals.
These two exceptions from paying penalties on early withdrawals from your 401(k) are relevant only if you are younger than 59½. Once you reach that age there are no penalties to deal with. Again, while you will be able to avoid the early withdrawal penalties using the 72(t) rules or the exception for those separating from service at 55 years old or older, you do need to consider the impact on ability to retire comfortably.
You can avoid the penalties, but remember that withdrawing these funds this early can put stress on the ability of your nest egg to last throughout your retirement.