Prior to receiving Social Security or a pension, you may have a need to create a stream of income to cover your living expenses. If this is the case, your company’s retirement plan (i.e., 401k, 403b, and 457b) may allow for periodic payments once you leave based on your life expectancy even if you’re under 55. Understand that once you decide to go down this path, you’ll have to continue taking payments for five consecutive years and until you turn 59 ½. Even though the withdrawals will be treated as taxable income, there’s no 10% early-distribution penalty.
There’s also the option of taking penalty-free distributions from your non-Roth company retirement plan at age 55. In order to qualify, you must leave the company at the age of 55 or older, and you can only take out the money in your 401k held with your current employer. This means that if you have a 401k with a former employer, you can’t take the money out before age 59 ½ without incurring a 10% early-distribution penalty. This obstacle can be avoided if your current employer allows you to roll over your 401k from a prior employer to the company’s existing plan.
You also have the option of taking periodic payments over your life expectancy from your IRA prior to reaching 59 ½ without paying a 10% early-distribution penalty. This option is available to you regardless of your age. As is the case with a distribution from an employer-sponsored retirement plan, withdrawals will be treated as a taxable income and any distributions from your IRA prior to age 59 ½ must continue for the longer of five consecutive years or until you turn 59 ½ before modifying any future distributions.
Note: Both of the early withdrawal options described above for company retirement plans (prior to age 55) and IRAs (prior to age 59 ½) are allowed under Section 72(t) of the Internal Revenue Code. Before selecting any of these options, make sure you fully understand the rules to ensure you don’t miss a crucial step/requirement and end up paying a 10% early-distribution penalty.
If you decide to go down the path of withdrawing retirement funds early, make sure you’ve evaluated all other available alternatives to cover your retirement expenses before choosing this option. Never underestimate the benefit of keeping your money in a retirement plan like a 401k or IRA and reaping the benefits of tax-deferred growth. By waiting to take this money out at the mandatory distribution age of 70 ½, you can spread the tax impact over your remaining lifetime. And when it comes to paying taxes, later is almost always better.