How to tap your retirement savings without getting hit with a stiff tax penalty — but only if you absolutely have to

  • You are allowed to take a series of equal payments from your IRA or your 401(k) without being subject to the 10 percent penalty, under certain circumstances.
  • Adhere to IRS rules on taking the payments or else face penalties and interest.
  • This is a move of last resort.
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If you are looking to to pull cash from your 401(k) plan or traditional IRA without getting hit with a penalty, the IRS will allow you to do it.

Generally, taking an early withdrawal from a qualified retirement account — that is, cashing out either of those accounts before age 59½ — results in a 10 percent penalty. In addition, you'll also need to pay income taxes on the distribution itself.

However, not all cash-outs are the same.

The IRS has defined a narrow set of circumstances in which it will waive the 10 percent penalty and permit you to take the early withdrawal. One of the lesser-known circumstances includes receiving a series of equal payments from your individual retirement account or your 401(k), which is known in tax circles as a "72(t) distribution."

Beware: Just because the IRS will allow this penalty-free cash out, doesn't mean you should take it.

"The first overriding factor is 'Never do it,'" said Ed Slott, CPA and founder of Ed Slott & Co. "You will have less money for retirement. It's the last resort unless you need it."

Here's what you need to know about pulling a series of payments from your retirement account.

It's complicated

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Generally, if you're drawing down money from your IRA, you need to figure out the amount of payments you'll receive, based on your age and life expectancy.

Once you start receiving the payments, you need to commit to taking at least one payment a year for five years, or until you reach 59½, whichever is longer. After the longer period of time is over, you can change your payment amount or stop the withdrawals.

The rules are slightly different for drawing down from a 401(k). In this case, you have to separate from service during or after the year you turn 55 in order to start taking payments.

"Once you start, you must keep going. You are stuck for at least five years." -Lisa Featherngill, CPA

Here's where things can get messy: If you make changes to your payments or if you go into the account to take an additional withdrawal while receiving the distributions, you'll face the 10 percent penalty retroactively for payments received, plus interest.

Even rolling a 401(k) into the IRA from which you're taking these payments can "break" your schedule and subject you to penalties and interest, Slott said.

"Once you start, you must keep going," said Lisa Featherngill, a CPA and member of the American Institute of CPAs personal financial planning executive committee. "You are stuck for at least five years."

No room for error

Retirement savings
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It's this lack of flexibility, along with the fact that you're using retirement dollars, that makes CPAs reluctant to recommend the 72(t) distribution.

"What if one day your roof needs to be replaced or you have an emergency medical expense?" asked Jeffrey Levine, CPA and director of financial planning at BluePrint Wealth Alliance.

"You'd have no choice but to break your payment schedule, go into the account and have a 10 percent penalty on everything you received prior to 59½," he said.

In a cash crunch, an emergency fund would be the best source of money, Levine said.

A home equity line of credit or even a 401(k) loan — provided you can pay it back — are preferable to taking equal payments from your retirement account, he said.

Alternative sources

While there are 72(t) calculators available online to help you determine your payment schedule, you should work with a professional before you proceed.

"The rules are very specific and detailed," Featherngill said. "Work with a CPA before you do it."

There might be other ways to use your retirement savings — if you absolutely have to — that might not be so rigid and punitive.

For instance, depending on whether your 401(k) allows it, generally you may borrow up to 50 percent of your vested account balance or $50,000, whichever is the lesser. You have five years to repay the loan.

In comparison, simply withdrawing the money from your 401(k) will result in a 20 percent withholding to cover your income taxes, plus a 10 percent penalty if you're under 59½.

Meanwhile, a "hardship withdrawal" from your account will be included in your gross income and may be subject to more taxes, but it won't be repaid to your plan. That means you've lowered your account balance permanently.

Finally, depending the circumstances of your emergency, the IRS may waive the 10 percent penalty for an early withdrawal from your IRA or 401(k) – and you won't have to take a set schedule of payments.

Unreimbursed medical expenses that exceed 7.5 percent of adjusted gross income (10 percent if you're under 65), total and permanent disability are among the situations that qualify.

"There may be options that you aren't considering," said Featherngill. "Just remember that the money coming out of the plan, unless it's a loan, is subject to income tax."

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