Penalty-Free Ways to Tap Retirement Savings

Even the best-laid financial plans can go awry when a major emergency strikes. Ideally, it’s best to have an emergency fund to pay for unexpected expenses, but a personal loan, low-interest credit cards, a line of credit, or help from family may also help you meet an immediate need for cash. The option of last resort should be your retirement fund. While accessing that money can seem attractive in an emergency, doing so can bring additional financial headaches – specifically, in the form of income taxes and, if you’re under 59 ½, a 10% penalty.

A 2021 survey by Bankrate among more than 2,000 Americans found that the prospect of taxes and penalties has not prevented people from tapping into their retirement savings. Of those with accounts like a 401(k) or IRA, 51% of respondents said they took an early withdrawal, including 20% who have taken one since the COVID-19 pandemic began in 2020.

In some cases, those who make early withdrawals from their retirement accounts can avoid having to pay penalties, although they will still owe taxes on the withdrawal. Withdrawals from 401(k) accounts and traditional IRAs made with pre-tax contributions are taxed as ordinary income. Those with Roth IRAs can withdraw their contributions at any time but must be 59 ½ to withdraw their earnings penalty- and tax-free as long as they’ve held the account open for at least five years. Depending on the employer’s plan, the same rules affect Roth 401(k)s. The IRS provides a handy chart of the long list of exceptions to the 10% penalty rule, covering anything from death, disability, medical expenses, medical insurance, and separation from service to potentially less urgent expenses, such as buying a first home or paying for qualified higher education expenses.

Immediate and Heavy Financial Need

Certain retirement plans may allow participants to take a “hardship distribution,” as long as the request meets certain criteria: First, there must be an “immediate and heavy financial need.” While the IRS doesn’t specify exactly what constitutes an immediate and heavy financial need, it does allow employers to determine whether a participant meets the criteria based on the plan terms and all relevant facts and circumstances. In its guidance, the IRS says an immediate and heavy financial need may qualify even if the participant could reasonably foresee a potential hardship or made the decision to incur the hardship voluntarily. However, overspending on consumer goods – such as a boat or TV – won’t likely qualify as a hardship. Any distribution should not be greater than the amount of the immediate and heavy financial need, including any taxes that need to be paid on it. In addition, the employee must have obtained all other available distributions and nontaxable plan loans. Finally, the employee can’t make elective deferrals to the plan for at least six months after the hardship distribution.

According to a safe harbor provision in the IRS regulations, distributions for the following situations meet the criteria for an immediate and heavy financial need:

• Medical care expenses for the employee, the employee’s spouse, dependents, or beneficiary.
• Costs directly related to the purchase of an employee’s principal residence (excluding mortgage payments).
• Tuition, related educational fees and room and board expenses for the next 12 months of postsecondary education for the employee or the employee’s spouse, children, dependents, or beneficiary.
• Payments necessary to prevent the eviction of the employee from the employee’s principal residence or foreclosure on the mortgage on that residence.
• Funeral expenses for the employee, the employee’s spouse, children, dependents, or beneficiary.
• Certain expenses to repair damage to the employee’s principal residence.
  Again, the distribution must only be enough to cover the need, and the employee couldn’t reasonably obtain funds from another source.

Consult Your Advisor Before Making a Withdrawal

The rules around penalty-free withdrawals are complex, and each employer’s plan may have different rules. If you feel a need to take an early distribution from your retirement savings plan, working with your financial and/or tax advisor can help ensure you won’t trigger a penalty or an unexpected tax bill.

This is intended for informational purposes only and should not be construed as personalized investment or financial advice. Please consult your investment and financial professional(s) regarding your unique situation.