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One of the trade-offs when investing in your 401(k) plan at work is that the money needs to stay in the plan (or an IRA or other qualified plan) until retirement. If you take money out too soon, the IRS will hit you with a 10% penalty for early distributions. If you take your money out too late, they will add a 50% penalty on distributions that fail to meet the IRS’ Required Minimum Distribution amount. This is on top of any taxes you may owe.
Eventually, most people will need to take income or a lump sum distribution from their 401(k).
Below are five ways to avoid IRS penalties on your 401(k).
Delay until after age 59 ½. To avoid an early withdrawal penalty, the IRS requires that you leave your money in your 401(k) or other qualified plan until age 59 ½ or longer. Taking a distribution earlier than that may result in a 10% IRS penalty on top of any taxes you may owe.
Once you turn 59 ½, however, there are no penalties for taking money out of your plan (with some notable exceptions which I will go into more detail below). After age 59 ½ you are free to take distributions from your 401(k) whenever you like and whenever you choose.
Take distributions under the “Age 55 Rule”. According to the IRS, if you separate from service at your job during the year in which you turn age 55 or later, distributions from your 401(k) are free from the early withdrawal penalty.
Keep in mind, you may not leave your job at age 54 and then take a penalty free distribution after you turn 55. These distributions would still be subject to the 10% early withdrawal penalty because you “separated from service” prior to the year you turned age 55. You must turn 55 the year you leave your job or later to avoid penalties on these distributions.
The Age 55 rule also does NOT apply to IRAs. It only applies to 401(k) and 403(b) retirement plans.
Avoid 60-day rollovers. A 60-day rollover is one in which you take money out of an IRA or retirement plan in the form of a direct payment made to you. You then have exactly 60 days to put that money back into an IRA or other qualified retirement plan. If you miss the 60-day window, the amount not rolled over is subject to taxes and a 10% early withdrawal penalty if you are not age 59 ½ or older and you do not qualify for the Age 55 Rule.
60-day rollovers are allowed only once in a 365-day period. So if you did a small rollover 300 days ago and then decided to rollover the rest of your plan within 365 days of the first rollover, the second one is taxable and subject to possible penalties.
To avoid this situation, consider a direct trustee-to-trustee transfer into an IRA or other qualified plan rather than a 60-day rollover.
For more information on the details regarding rollovers read this article on the IRS website.
Know the pitfalls of 401(k) loans. If your 401(k) has a loan provision, you may choose to borrow money against your 401(k) balance. Doing so isn’t inherently a bad idea, but if you fail to meet the requirements for repayment or if leave your job for any reason, the entire loan amount can become taxable, and if you are under age 59 ½, subject to the 10% early withdrawal penalties.
The rules on 401(k) loans have relaxed a bit in recent years. Thanks to the Tax Cuts and Jobs Act of 2017, you now have until the tax filing deadline (usually April 15th) of the year following termination of employment to pay off your 401(K) loan and avoid taxes and possible penalties.
So, if you took out a 401(k) loan and lost your job in 2020, you have until your tax filing deadline (now May 17th with the recent IRS extension) to pay back that loan amount.
In case you are wondering exactly what the IRS says about that, you can read more about it here.
Do not miss your RMD. Most penalties on retirement plan distributions apply to early distributions. In some cases, retirees may choose to delay taking distributions from their retirement plans up to age 72.
The penalty for a missed or inadequate Required Minimum Distribution (RMD) is 50% of the RMD amount. If you took a partial distribution, but not the full RMD amount, the penalty is 50% of the difference.
Unlike IRAs, RMDs from 401(k) plans can not be aggregated. If you have two or more 401(k) plans, you must take an RMD from each one separately. In some cases, workers may avoid RMDs on the 401(k) of their current employer; however, not every 401(k) plan allows for this feature. Check with your plan administrator for the details regarding your specific retirement plan.
To discuss any of the topics in this blog or to learn more about how we can help you Cross The Bridge To A Confident Retirement, please contact me through my web site mikebranch.net, call me directly at 651-379-3935 or email me at mpbranch@focusfinancial.com.