While each retirement plan has similar early withdrawal penalty exemptions, they are not all alike. Knowing these subtle differences within 401(k) plans can create an avoidable 10% tax penalty if you take money out of the plan prior to reaching age 59 1/2. This is true because a simple roll-over of funds into an IRA is a readily available option to avoid the penalty. You should consider rolling over your 401(k) into an IRA prior to early distribution when:
- Using Retirement Funds for Qualified Higher Education Expenses. Want to use retirement funds to pay for college? Make sure you pull the funds out of an IRA and not another retirement account type or you could be subject to an additional 10% early withdrawal penalty. After rolling the funds into an IRA, the funds can be used penalty-free as long as they are for qualified educational expenses at a qualified school.
- Using Retirement Funds to Buy, Build, or Rebuild a First Home. You may use up to $10,000 of your IRA per person to purchase a first home and avoid paying the 10% early withdrawal penalty. If these same funds are pulled out of a 401(k) plan you could be subject to an additional federal tax of up to $1,000. Roll the funds to a Traditional IRA first, and save the tax!
- Using Retirement Funds to Pay for Medical Insurance. There is also a provision for an unemployed individual to use IRA funds to pay for medical insurance. This provision does not exist in 401(k)s, so to avoid the early withdrawal penalties, roll the money from your 401(k) into an IRA prior to using the funds to pay for your insurance premiums.
Remember, by rolling the funds prior to pulling the funds for pre-retirement distribution you are avoiding the early withdrawal penalties, but you must still pay the applicable income tax.
Bonus Retirement Plan Tips.
Two other quirks in the retirement tax code to be aware of;
- Early Distributions from a SIMPLE IRA Could Cause a 25% Penalty. The early distribution penalty of 10% increases to 25% for those in SIMPLE IRAs, if the withdrawal occurs during a 2-year time period starting from your initial enrollment date in the SIMPLE plan. You may not roll your funds into another retirement plan type during this 2 year period to try to avoid the increased early withdrawal penalty.
- Minimum Distributions are Required from ROTH 401(k)s but not ROTH IRAs. In an unusual quirk in the tax code, if you have a ROTH 401(k) you are required to make minimum required distributions from this account like other 401(k)s and IRAs when you reach age 70 1/2. If, however, you roll the ROTH 401(k) funds into a ROTH IRA you are no longer subject to the minimum distribution rule requirements.