Penalty-free 401(k), IRA withdrawals
It always seems to cost a lot of money whenever life goes off the rails into uncharted chaos territory. After the emergency fund is drained from too many emergencies, where can you turn? For many people their biggest stash of savings is hidden away in tax-advantaged retirement accounts.
Unfortunately, the government imposes a 10 percent penalty on any withdrawals before age 59 1/2. Some early distributions qualify for a waiver of that penalty -- for instance hardships, higher education expenses and buying a first home.
Though the IRS does not recognize being flat broke as a hardship, there are situations when investors can tap their retirement plan before age 59 1/2 without forking over 10 percent to Uncle Sam.
First draw from emergency fund
Any thoroughly researched discussion on early withdrawals from a retirement account should begin with a firm reminder on the importance of keeping an ample emergency fund.
However, if you're considering taking money out of a retirement account early, it's very likely that the emergency-fund horse has already left the barn, so to speak.
"There are three levels of liquidity. People should have an emergency fund. The next level is investment accounts. And the next is retirement accounts," says Bonnie Kirchner, author of "Who Can You Trust With Your Money?"
"Even though (a retirement account) is a source of liquidity in an emergency, they should really try not to touch it," she says.
Now that you're properly chastised, 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 Contributions to a Roth IRA can be taken out at any time, and its earnings may be withdrawn penalty and tax-free after five years.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.
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, Conn.
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.
"That is excellent proof that you are disabled, if you're getting benefits from the government and from a private insurance carrier," he says.