Penalty-free does not mean tax-free
If you do need to take a withdrawal, some hardship situations qualify for a penalty exemption from an IRA or a 401(k) plan.
Note that penalty-free does not mean tax-free. All traditional IRA and 401(k) withdrawals require that you pay taxes at ordinary income rates. Contributions to a Roth IRA can be taken out at any time, and its earnings may be withdrawn penalty-free and tax-free after five years. The same rules apply to a Roth 401(k), but only if the employer plan permits.
In certain situations, a traditional IRA offers penalty-free withdrawals even when an employer-sponsored plan does not. We explain those situations below. Also, be aware that employer plans don't have to provide for hardship withdrawals at all. Many do, but they may permit hardship withdrawals only in certain situations -- for instance, for medical or funeral expenses, but not for housing or education purposes.
These circumstances qualify for IRS-sanctioned, penalty-free hardship withdrawals.
1. Unreimbursed medical bills
The government will allow investors to withdraw money from their qualified retirement plan to pay for unreimbursed deductible medical expenses that exceed 10 percent of adjusted gross income.
The withdrawal must be made in the same year that the medical bills were incurred, says Alan Rothstein, a CPA at Rothstein & Co., in Avon, Connecticut.
You do not have to itemize deductions to take advantage of this exception to the 10 percent tax penalty, according to IRS Publication 590.
The IRS dictates that investors must be totally and permanently disabled before they can dip into their retirement plans without paying a 10 percent penalty.
Rothstein says the easiest way to prove disability to the IRS is by collecting disability payments from an insurance company or from Social Security.
3. Health insurance premiums
Penalty-free withdrawals can be taken from an IRA if you're unemployed and the money is used to pay health insurance premiums. The caveat is that you must be unemployed for 12 weeks.
To leave a clean trail just in case of an audit, Rothstein suggests opening a separate bank account to receive transfers from the IRA and then using it to pay the premiums only.
"Or the best way is to have the money sent to the insurance carrier directly," he says.
When an IRA account holder dies, the beneficiaries can take withdrawals from the account without paying the 10 percent penalty. However, the IRS imposes restrictions on spouses who inherit an IRA and elect to treat it as their own. They may be subject to the penalty if they take a distribution before age 59 1/2.
5. If you owe the IRS
If Uncle Sam comes after your IRA for unpaid taxes, or in other words, places a levy against the account, you can take a penalty-free withdrawal, says CFP professional Joe Gordon, co-founder of Gordon Asset Management in Durham, North Carolina.
6. First-time homebuyers
Though you may take money out of your 401(k) to use as a down payment, expect to pay a 10 percent penalty.
However, take the money from your IRA, and it's penalty-free. The penalty-free withdrawal is not limited to first-timers either. Homebuyers must not have owned a home in the previous two years, though. Further, you can take more than one penalty-free withdrawal to buy a home, but there is a $10,000 limit.
For example, says Rothstein, "You can do two $5,000 withdrawals, but $10,000 is the lifetime limit."
Taking money out of a 401(k) for a down payment can be trickier.
"When the 401(k) has both a loan provision and hardship withdrawal provision, the participant must first use the loan provision before going to hardship," Gordon says.
7. Higher education expenses
Similarly, withdrawals can generally be made from a 401(k) to cover higher education expenses if the plan allows hardship withdrawals, but they will be subject to the 10 percent penalty.
However, IRA withdrawals are penalty-free if used to pay for qualified expenses.
"It can be for yourself, your spouse, children, grandchildren, immediate family members. Typically, it will cover books, tuition, supplies, room and board and for postsecondary education," says Bonnie Kirchner, author of "Who Can You Trust With Your Money?"
8. For income purposes
Section 72(t) of the tax code allows investors to take money out of their retirement plan for income, but there are restrictions.
"You'll have to take substantially equal periodic payments" over time, Kirchner says.
The shortest amount of time that payments must be made is five years. One option is taking a distribution annually for five years or until age 59 1/2, whichever is longer.
For example, early retirees may want to tap their retirement accounts before Social Security kicks in.
"The gist is that you take the payments and you pay the taxes, but you pay no penalty even if you're 52 or 53 years old," Gordon says.
There are other options for the distributions that allow an investor to take payments "over their life expectancy or do a reverse-mortgage-type amortization," Gordon says.
These periodic payments can also be spread over the course of your life and that of your designated beneficiary.