How to Retire Early on a 401k With No Penalty

Normally, if you withdraw money against your 401k retirement plan before the age of 59 1/2, you pay both income tax on the withdrawal and a 10 percent penalty. However, if you're looking to retire early on a 401k with no penalty, you can sidestep it by drawing out the money in what will be considered "substantially equal payments" spread over the remainder of your life.          

Suggestions

1. Divide the amount of equity built up in your 401k by the number of years remaining in your life expectancy. For example, if you are 50 years old and have $250,000 in your 401k, your life expectancy will have approximately 25 years remaining, for a penalty-free withdrawal of $10,000 per annum.
2. Visit your bank or financial advisor to discuss setting up an annuity plan that would see you withdraw the required amount of money each year.
3.  Continue to receive your annuity without adjusting the amount you are paid each year, unless it is absolutely necessary. If your payments drop below your established threshold, the Internal Revenue Service will come looking for the 10 percent fee you're trying to avoid.
4. Retire on your 401k early by waiting until you're as close to the age of 59 1/2 as possible. Not only will that increase the amount of your annuity, it will also make it easier for you to adjust the amount of the annual payment downward with no penalty. IRS regulations state you will face the 10 percent penalty if you adjust the amount of the annual payment within the first 5 years of your plan, but you are exempt from this technicality after the age of 59 1/2.
5. Factor marriage into the equation. If a married couple decides to withdraw annual payments together and one spouse passes away, the rules change. If the deceased was aged 59 1/2 or younger, or if the payments had been taken for at least 5 years, the surviving member of the couple is entitled to readjust the payments with no penalty.

Tips

• "Substantially equal payments" is not the only way the Internal Revenue Service will permit you to take money from your 401k with no penalty. If you have significant medical expenses, want to make a down payment on your first home or suffer a disability, you might also qualify for penalty-free withdrawal of your 401k equity.
• Remember that life expectancies are determined according to actuarial tables if you plan to use your 401k to retire early. Your remaining life expectancy is determined by the financial institution, not by you.
• You must draw money from your 401k every year, or your previous drawings may become subject to the 10 percent penalty, as well as income tax arrears.

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How to Calculate a Cash Out of a 401(k)

401k retirement plans are an employer-sponsored benefit that allow you to save money for retirement. Given the time to grow, 401k plans can provide you with financial security in your retirement years. However, sometimes circumstances require you to access your 401k funds to take care of emergencies such as medical treatment or to save your home from foreclosure. If you need to cash out your 401k, several factors can influence how much cash you will actually get.

Instructions

1. Obtain your current 401k balance by contacting your 401k Plan Administrator or by accessing your account through your plan's website.
2. Add the balance of any 401k loans that you may currently have out. How the loan is treated during a cash-out varies by plan. Some plans instantly include the loan proceeds as part of your 401k balance for purposes of calculating taxes and penalties. If you lose or quit your job, the loan may be considered due in full immediately. If you have not repaid the loan in 60 days, it will then be considered taxable income, subject to the same taxes and penalties as the remainder of your 401k balance.
3.   Subtract 10% of the full balance (including loan distributions) of your 401k account. Early withdrawals are instantly hit with a 10% penalty by the IRS unless you can qualify for a hardship or other penalty-free type of early withdrawal.
4. Calculate the amount of federal tax that will be withheld on the full balance of your 401k account. The tax will be based upon your IRS Income Tax bracket, which is based upon your annual income.
5. Calculate the amount of state tax to be withheld from your full 401k account balance. You can find your state's income tax rate by contacting the state department of taxation where you reside.
6. Subtract any administrative fees from the remaining balance. You can find out exactly what fees apply by contacting your plan administrator or by reading your 401k Summary of Benefits statement.
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Tips

•  If at all possible consider other alternatives, such as home equity or 401k loans, to avoid paying massive penalties on your 401k distribution.

• If you have been the victim of a natural disaster and a Federal Disaster Declaration has been issued for your area, you may qualify for a hardship withdrawal. IRS Publication 575 contains current information about this 401k penalty exemption. 

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Reasons You Can Make Early Withdrawals From Your 401(k) Without Paying a Large Penalty

Your 401(k) plan is a tax-deferred investment account that allows your investments to grow tax-free until you withdraw money after you reach retirement age. Money you contribute to your plan comes from your pretax income, and generally you cannot withdraw it without paying a penalty until you reach 59-1/2 years of age. Under certain circumstances you may withdraw money early, but in most cases you will have to pay a penalty.          

Hardship Withdrawals

If your particular 401(k) plan allows for it, you can take a hardship withdrawal for certain circumstances spelled out in your plan's prospectus. Not all plans allow this, but if yours does, you may take an early withdrawal to pay for items such as funeral expenses, home repairs and education expenses. However, if you are not yet 59-1/2, you will be required to pay a 10 percent early withdrawal penalty even on hardship withdrawals unless you are taking your withdrawal because you have become disabled, or to cover medical expenses that exceed 7.5 percent of your income, or you have been terminated from your job and you are at least 55.

IRS Rule 72(t) Withdrawals

Anyone can take early withdrawals without penalty under Internal Revenue Service Rule 72(t). This rule allows you to take early annual distributions from your plan based on your life expectancy. Your life expectancy is determined based on actuarial tables used by the IRS. Bankrate.com and many other websites have calculators on their sites to help you figure the amount you can take out each year under this rule. If you opt for this plan, you must take the same amount out of your account each year and pay income taxes on it. Your withdrawals must continue for at least five years and you can't contribute to your plan during that time.

401(k) Loans

Many 401(k) plans allow you to take a penalty-free, tax-free loan from your account. In this case, you may borrow up to 50 percent of your account balance. As long as you pay back your loan on a timely basis with interest -- usually within five years -- you will not be penalized. If your investments are earning a higher return than the interest you pay back on your loan, it might be cheaper for you to seek a loan from a lender rather than use money in your 401(k).

Regular Distributions

Once you reach 59-1/2, the money in your 401(k) is yours for the taking. You can withdraw the entire amount of your account in one lump sum if you wish. Or you can take regular distribution payments each year. Either way, you won't have to pay any penalties on your withdrawals, but you will have to pay income taxes on anything you take out.

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How to Cash out a 401(k) After a Job Loss

You can save money for your retirement years by putting a portion of each of your pay checks into your company's 401k account. If you lose your job, you can liquidate that money and use it supplement your income now rather than when you are retired. You have to pay income tax on the money that you withdraw from your 401k, and if you are under the age of 59 1/2, you also have to pay a 10 percent tax penalty. However, many unemployed people have no alternative but to pay the penalties and cash in their accounts.

Suggestions

1. Contact the Human Resources department of your former employer and ask for the contact information for the company's 401k custodian. Explain that your are no longer employed by the firm, as many companies have different divisions that deal with either current or former employees.
2. Contact the 401k custodian and identify yourself by providing your name, date of birth and Social Security number. Ask the representative how much you have in your account and how much of that money actually belongs to you. Many companies have vesting schedules, meaning that the employer made contributions that do not technically become yours until a few years after the contributions have been made.
3. Ask the representative to liquidate your account and either mail you a check or wire the proceeds to your checking account. It normally takes seven to 10 days to receive a check, whereas wired funds are normally available the next day, although you may have to pay a fee to have funds sent electronically. The custodian has to withhold 20 percent to cover federal tax, and you can ask the custodian to withhold extra funds for tax if you have to pay the 10 percent tax penalty. You can also opt to pay the additional tax when you file your taxes.
4. Review the disbursement check and the attached 401k disbursement statement to find out the closing balance of your account. Fund values update nightly, so your custodian cannot tell you how much your funds are worth until after the funds have been sold.

Tips

• Generally, you have to pay the 10 percent premature withdrawal penalty when you access your 401k funds prior to reaching age 59 1/2. However, the Internal Revenue Service makes an exception for people who are age 55 or older. Such people can access 401k funds without incurring the penalty when they experience a separation of service.
• When you cash in your 401k, the Internal Revenue service treats the disbursement as taxable income, and you may also have to pay state taxes on the funds that you receive. However, some states reduce or stop your unemployment benefit when you cash in your 401k. Therefore, contact your state's unemployment office to find out how a 401k distribution will impact your unemployment benefit, because you cannot reverse the disbursement after you receive the money.

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