If you have a pressing need for cash before you reach 59-1/2, there are ways to tap your retirement plan without paying a penalty tax. In fact, you may be able to get your hands on your money without paying any tax at all-by borrowing from your plan.
Advantages: Many plans allow participants to borrow from their accounts, tax-free, with little paperwork. You have to repay those loans but your payments go back to your own account. You wind up paying interest to yourself rather than to a bank or finance company.
Disadvantages: Long-term, you’ll probably get higher returns investing 401(k) money in stocks than in any types of loans. If you leave your employer you’ll have to repay the loan right away. Otherwise the loan will be re-cast as a taxable withdrawal and the 10% penalty may apply if you’re under 59-1/2.
If a loan isn’t a practical choice, you’ll have to pay tax on a retirement plan withdrawal but you may be able to dodge the 10% penalty by using these exceptions:
- Death. If you inherit a retirement plan you can withdraw the funds and avoid the 10% penalty, no matter what your age.
- Disability. If you’re receiving a disability check from Social Security or from a disability insurance policy because you can’t work, the 10% penalty probably won’t be assessed.
- Substantially equal periodic payments (SEPPs). To avoid the penalty, SEPPs must be based on your life expectancy. Once started, they must continue for at least five years, or until 59-1/2, whichever comes later.
- Medical expenses. The 10% penalty will be waived in the case of money withdrawn up to the amount of deductible medical expenses.
