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The US government uses retirement accounts, such as 401k plans and IRAs, to encourage retirement savings. The money that goes into these accounts does not pay income taxes.
If the person wants to make early withdrawals, they will have to pay taxes on the money they withdraw and a penalty of 10% of the amount of the withdrawal.
Example. Ana withdraws $1,000 from her retirement plan. She must include this money on her tax return and, in addition, pay a $100 penalty.
However, in the following circumstances, it is allowed to withdraw the money by paying the taxes, but not the 10% penalty.
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Withdrawals from a 401k account
Death
The death of the owner of the retirement plan allows beneficiaries of that plan to avoid the 10% penalty. If the beneficiary was married to the decedent, this beneficiary can put those funds into his or her own retirement plan. If the beneficiary decides to put the funds into her own plan, he will no longer be able to withdraw them until he turns 59.
Disability
You can take money out of your retirement account if you have a disability. The law defines disability as the inability to “have gainful employment due to a medically determinable physical or mental impairment that has a prognosis of death or of long-term or indeterminate duration.”
Substantially equal periodic payments
Another way to avoid the penalty is to make withdrawals of substantially equal payments. This can be done at any age if you meet the following requirements:
- The plan owner must use one of three Internal Revenue Service (IRS) calculation methods to determine how much money to withdraw.
- Withdrawals must be substantially equal.
- Withdrawals must be made for the life of the plan owner.
Finish a job after 55
If a person quits, is fired, or retires from a job after age 55, they can withdraw money from their 401k retirement plan with that employer. These are the conditions:
- Retirement must be after termination of employment
- The plan owner must be at least 55 years old as of December 31 of the retirement year
- This exception does not allow withdrawals from IRA accounts.
Medical expenses
In some circumstances, it is permissible to withdraw money from a retirement plan for medical expenses without paying the 10% penalty. The law allows the withdrawal of money to pay medical expenses that exceed 7.5% of your adjusted gross income.
Example Adrian has an adjusted gross income of $30,000. In 2020, Adrian has coronavirus and has a medical bill of $3,000. 7.5% of Adrian’s adjusted gross income is $2,250. Therefore, he will be able to withdraw $750 from your retirement account, which is the difference between the $3,000 in medical expenses and the $2,250.
Dividends from employee stock plans
Employee stock plans (ESOPs) are a way to deliver company stock to workers in their retirement accounts. Some of these plans allow distributions of money. If the worker chooses these cash distributions, they will not be subject to the 10% penalty.
Payments pursuant to a Court Order
If there is a qualified domestic relations order (QDRO), you can take money out of your retirement account to pay alimony or spousal support that the order says.
Refunds
Refunds for contributions that exceed the legal limit do not pay the 10% penalty when the plan administrator makes a distribution of money to remedy the excess. In order for the penalty to be waived, the distribution must occur before the plan owner files their tax return with the IRS.
Example Susana puts $20,000 into her 401k plan in 2020. The maximum contribution for 2020 was $19,500, so Susana will be able to withdraw $500 without penalty. She must make the withdrawal before submitting her 2020 tax return.
Loans
Some 401k plans have specific provisions that allow their owners to take loans against their 401k investments. If your 401k plan allows loans, then the IRS will allow you to borrow up to 50% of your account balance up to a maximum of $50,000. The loan must be repaid within 5 years.
Loans are the only mechanism that allows you to avoid both the 10% fine and taxes.
Special exceptions for IRA plans
There are special rules for IRA accounts. These accounts allow withdrawals in the following situations:
Health Insurance Premiums
If you use a withdrawal to pay health insurance premiums when you’re unemployed, those withdrawals won’t pay the 10% penalty. To do this, you must meet the following conditions:
- Have received unemployment compensation for at least 12 weeks in a row.
- If you returned to work, the withdrawal cannot be later than 60 days from when you started your new job.
If you are self-employed, you may also qualify for a penalty-free withdrawal.
Education Expenses
If you take money out of your IRA to pay for higher education expenses, you don’t have to pay the 10% penalty. You must meet the following conditions:
- The withdrawal must be to pay educational expenses, such as tuition or books.
- The withdrawal may cover the expenses of the account owner or their spouse, children or grandchildren.
Purchase of the first house
First-time homebuyers can withdraw money from their IRA under the following circumstances:
- Withdrawal must be used to purchase property within 120 days of withdrawal.
- The money can go to the benefit of the account owner or their ancestors, spouse, children or grandchildren.
- You can withdraw up to $10,000.
Refund
If an IRA owner contributes more than the legal limit, they can withdraw the excess without paying the penalty. To do this, he must make the withdrawal before submitting his tax return.
Example Richard contributes $7,000 to his IRA in 2020. Because the IRA contribution limit was $6,000 in 2020, Richard can withdraw $1,000 without penalty.