As a general rule, you will incur a 10% penalty tax in addition to regular income taxes if you take a distribution from your 401k prior to age 59½.
There is, however, an opportunity to withdraw penalty-free savings from your 401k at age 55. There are two criteria you’ll need to meet in order to be eligible:
- You are no longer employed by the employer with whom the 401k is affiliated.
- You left that employer during or after the calendar year in which you reached age 55.
Below are a few additional considerations to keep in mind if you’re considering 401k withdrawals from an old employer between the ages of 55-59½.
It doesn’t matter why you severed employment with the old employer.Whether you were fired, quit or were laid off, as long as you are no longer employed by the employer maintaining the plan, you will qualify for penalty-free early withdrawals from that 401k as long as employment was terminated during the year of your 55th birthday or later.
These early 401k withdrawal age rules only apply to the assets in the 401k in the plan that’s maintained by your former employer.Assets in an IRA have their own rules regarding a penalty-free early withdrawal. In a similar vein, assets that you’ve rolled over from your 401k to an IRA will generally no longer be eligible for penalty-free early withdrawals unless you qualify for a different exemption (there are number of exemptions you may qualify for; you should consult your tax advisor to see which exemptions apply). If there’s a possibility you may need to tap into the savings in your 401k, you may want to hold off on rolling those assets over to an IRA until you turn 59½.
You don’t have to be retired to avoid paying the penalty.If you have a 401k with Company ABC and retire at age 58, you’ll be able to access those savings without penalty, even if you immediately take a job with Company XYZ.
The age 55 rule applies to the date employment was terminated, not when you begin taking distributions.
For example, if you retired from Company ABC at age 50, you would still be subject to the penalty tax if you take distributions at age 55; you’d have to wait until age 59½ for penalty-free withdrawals.
It’s possible you may be able to take withdrawals from multiple 401k accounts without penalty.Let’s say you retire from Company ABC at age 57 and immediately take a job with Company XYZ. After a year, you decide you’re ready to retire for good at the age of 58. You could take penalty-free distributions from the 401k plans administered by Companies ABC and XYZ.
It’s often better to let the money in your 401k grow for as long as possible in order to capitalize on years of tax-deferred or tax-free growth, but in the event you need to tap into those savings at a younger age, make sure you’re following all of the rules to avoid penalties and following your comprehensive financial plan.
At Wealth Enhancement Group, we’ve built something special: a software-based tool we call RealityCheck. It translates abstract investment statistics into a real-world projection: how much retirement income you’ll have to live on. It’s also a bit of a play on words because your retirement income needs to replace that paycheck you currently rely on.
The opinions voiced in this material are for general information only and are not intended to be a substitute for specific tax advice for any individual. We suggest that you discuss your specific tax issues with a qualified tax advisor.
Michael Bishop has been with Wealth Enhancement Group for more than 10 years. He uses his multiple professional designations better serve his clients.