Advisors Urge Caution On Penalty-Free IRA, 401(k) Early Withdrawals

Investors in tax-deferred retirement accounts such as IRAs and 401(k)s are subject to heavy penalties if they touch the money before the age of 59½. But there are ways to make early withdrawals without penalties.

Still, advisors say clients need to be wary of such moves.

“Taking money out of a tax-advantaged retirement account to fund anything but a client’s intended purpose of funding retirement would be a last-resort recommendation,” said Anisa Dunn, a senior vice president at Johnson Financial Group in Milwaukee. “We would recommend it only if a client was truly in a position that would qualify as a hardship and didn’t have other liquidity options available.”

These “other liquidity options” include savings accounts and investment accounts that aren’t tax-advantaged, she said. “I’d also look to see if the client may have lending options,” she added, such as a home equity line of credit.

“The need to tap into retirement funds at a young age shows a breakdown in planning,” Dunn said. “You should not aggressively save toward retirement until you can afford to comfortably handle short-term emergencies.”

One way to handle such emergencies is with a dedicated rainy-day fund, suggested Brian Severin, senior executive vice president at Mutual of America Financial Group in New York City. “Setting up a separate emergency fund in a no-fee savings account would give you easy access to money when experiencing hardship, without losing future savings intended for your retirement,” he said. “What’s more, this provision may even encourage people to get more into the practice of saving for retirement without being concerned that their money would be unavailable for an emergency.”

Unusual Hardships

Absent these options, clients who meet certain conditions can choose to take early withdrawals from retirement accounts without penalty.

“For many people, their retirement account is their biggest asset. So when they fall on tough times, they tap the account,” said Sarah Brenner, director of retirement education at Ed Slott & Co., a tax-consulting firm in Rockville Centre, N.Y.

She said that there are more than 20 situations that qualify for penalty-free retirement account withdrawals, including having a terminal illness or permanent and total disability, surviving a natural disaster or domestic abuse, buying health insurance if unemployed, funding higher education or a first home, and having other “unforeseeable or immediate financial needs relating to personal or family emergencies.”

But every case has its own limits and criteria. “You must meet all the requirements,” said Brenner. “Sometimes, like for disability, the bar is very high.”

In general, you can self-certify your need to withdraw funds, she said, but the IRS may question you later on. “We have seen taxpayers lose in tax court when they could not prove that an exception to the penalty applied,” she said.

Each waiver category has its criteria for acceptability. “The bar for obtaining a penalty waiver can vary, and it's essential to adhere to the IRS guidelines,” said Michael Green, managing director and senior wealth advisor at GYL Financial Synergies in Parsippany, N.J.

But the rules aren’t always difficult, said Salvatore Capizzi, chief sales and marketing officer at Dunham & Associates Investment Counsel in San Diego. For example, you can remove up to $5,000 from a retirement plan or IRA at the birth or adoption of a child, he said, and this “does not require tax records, just a child and a statement that provides the [child’s] name, age, and Social Security number.”

In some cases, the SECURE 2.0 Act has lowered the bar. “It expedites the process for getting emergency funds after a natural disaster,” said Tom Granger, a vice president at Security Benefit in Topeka, Kan., “ensuring participants have the necessary funds to rebuild.”

It also made it easier for employers to honor early withdrawal requests, said Todd Feder, a senior retirement plan consultant at Girard, a division of Univest Wealth in Souderton Pa. Employers, he said, are no longer required to verify documentation for hardship distributions.

The Details

The amounts that can be withdrawn vary, said Ed Slott & Co.’s Brenner. Survivors of natural disasters can take out up to $22,000 without penalty, whereas survivors of domestic abuse may withdraw no more than $10,000 or 50% of their account, whichever is less. If you’re diagnosed with a terminal illness, defined as having seven years or less to live, you can withdraw any amount. And those with just about any kind of unforeseen emergency can take out up to $1,000 per year.

“The penalty exceptions are tricky,” she stressed, adding that some of the penalty waivers apply only to IRAs, others only to 401(k)s, and still others to either one.

For instance, she said, if you have a terminal illness, permanent disability, or excessive medical expenses, or if you are a survivor of domestic abuse or a federally declared disaster, you can take early withdrawals from all types of retirement accounts. But if you need funds for higher education, health insurance while unemployed, or purchasing a first home, you can only take a penalty-free distribution from an IRA, SEP IRA or SIMPLE IRA.

In contrast, she said, police officers, firefighters, emergency medical workers and other public or private-sector safety officials who are at least 50 years old or have worked in their jobs for at least 25 years can take early, penalty-free withdrawals from their employer-sponsored retirement accounts—but not from their IRAs.

“Many advisors who are not experts in retirement plans are not familiar with the nuances of the early-distribution penalty exemptions,” said Avery Neumark, senior consultant to CBIZ Marks Paneth, an accounting firm in New York.

Whether or not to exercise these options is another matter. “You need to consider the ramifications,” said Erin Wood, a senior vice president at Carson Group in Omaha. “Any money withdrawn from the account is money that will lose out on future growth. This could be the difference between someone reaching their retirement goal or not.”

On the other hand, she said, “advisors are often heavy-handed with the ‘never take early withdrawal’ advice. If the client doesn’t use the money when true emergencies occur, they might rely on avenues that will have worse consequences.”

For instance, she said, the allowance for domestic abuse survivors could be “the difference between someone being able to start fresh or being trapped in an abusive situation.”

Early retirement-fund withdrawal can also be a better option than “taking a high-interest loan or [agreeing to] other unfavorable terms to borrow money,” said Eugene Lev of Signature Estate & Investment Advisors in Los Angeles.

Be aware, though, that even if the early-withdrawal penalty is waived, the distribution counts as taxable income. “You will still have to pay federal and state taxes,” he said.

As seen on Fa-mag.com