After 30 years as a police officer, I’m retiring at age 53. I’d like to ask about retirement plan withdrawals.
I want to take about $50,000 out of my 401(k). When I take it, they will withhold 20 percent for taxes and the 10 percent penalty for early withdrawal will not apply, correct?
Incorrect. There are ways to avoid the 10 percent federal penalty on a premature 401(k) withdrawal, but you haven’t mentioned anything that would indicate you qualify.
Typically you have to be 59 1/2 to bypass the penalty on a lump-sum retirement plan withdrawal. Or, you have to be 55 or older when you leave your job to qualify for the “separated from service” exception that waives the penalty.
Since you’re younger than that, your options are more restricted. You could start taking “substantial equal periodic payments” based on your life expectancy, but those withdrawals are likely to be a lot smaller than $50,000, and they have to continue at least five years or until you turn 59 1/2, whichever is later. (If you think this might be an option, consult a tax pro for details.)
You also may avoid the penalty if you’re using the money to pay unreimbursed medical bills that exceed 10 percent of your adjusted gross income or if you are totally and permanently disabled.
The 20 percent withheld from your distribution may not be enough to pay the income taxes you’ll owe, by the way. You may owe more come April 15 if your tax bracket is higher. Between state and federal taxes and penalties, people often give Uncle Sam one-quarter to one-half of their premature retirement plan withdrawals.
Perhaps the biggest penalty, though, is all the tax-deferred gains you give up on every withdrawal. If left alone, that $50,000 could nearly double in 10 years at a 7 percent average annual growth rate. That’s why people who are smart about money generally try to avoid breaking into their nest eggs early.
Ask the adviser