How to Avoid a Penalty for an Early Ira or 401k Withdrawal

When faced with economic challenges, it may be tempting to consider a withdrawal from a retirement account. While it is not possible to avoid paying taxes on this type of withdrawal, there may be some ways to avoid a penalty for an early IRA or 401(k) withdrawal.

Both plans not equal

It is important to remember that these retirement plans are not created equally. In most cases, IRA accounts are self-directed while 401(k) plans are typically subject to an agreement entered into with an employer.  While most users have 100 percent unfettered access to an IRA, 401(k) plans may be subjected to a vesting period. In these cases, employees typically have immediate access to the portion of their 401(k) that they deposited while employer matching deposits are vested on a schedule explained in the plan documents.

Loans against retirement accounts

Many 401(k) plans offer a loan provision that may be used when the account owner is in need of additional money.  However, an IRA plan (unless it is a special employer offered plan) does not offer this provision. Those who are able to take a loan against a 401(k) plan will not suffer any tax or penalty consequences.

Retirement account withdrawals

Under very specific conditions, participants in IRA plans and 401(k) plans can withdraw money from their accounts.  These conditions have to fall under the Internal Revenue Services description of a hardship withdrawal.  Some examples of hardship withdrawals include:

First home purchase – both IRA and 401(k) account holders can take a penalty-free withdrawal for the purpose of aiding them in purchasing their first home. In the case of an IRA distribution, taxpayers must file Form 5329 with their tax return. While these distributions are not tax free, they are penalty free.

Unusual medical expenses – both IRA and 401(k) plans provide for hardship withdrawals for unusual medical expenses or for payment of medical premiums. In the case of expenses, these payments must be “unusually high out of pocket” expenses to qualify for a penalty waiver. In the event that the withdrawal is made to pay insurance premiums, the account holder must be unemployed.

Tuition expenses – when funding a college education for a family member (adult or child) the IRS allows retirement plan owners to take a hardship withdrawal. This is allowed in the case of an IRA as well as a 401(k) plan.

Foreclosure or eviction – this hardship is allowed from most 401(k) plans but not allowed with IRA plans. In the case of an IRA the funds would be subject to penalty as well as to taxes as a distribution.

Words of warning

When considering taking a withdrawal from an IRA plan or from a 401(k) plan there are some things that must be considered. In the case of an IRA, if the account owner believes they can reinstate the funds within 60 days, there is no penalty charged or taxes due. In the event that a hardship withdrawal is made from a 401(k) plan, the owner is not able to redeposit the funds nor are they able to make additional contributions for up to six months depending on the plan.

Economic challenges can make it very tempting to take funds from a retirement plan to help get through difficult times. However, retirement account owners should be aware of how to avoid a penalty for an early IRA or 401(k) withdrawal as well as understand the tax ramifications. In most cases, these funds cannot be deposited back to the retirement plan, jeopardizing earnings and available retirement benefits.