In most cases, if you pull money out of a “retirement plan” before age 59 ½ you have to pay a 10% penalty to the IRS on any amount distributed. However, there are a couple ways this can be avoided. Read on to discover how.

Rule #1: Creating income in an early retirement

Rule #2: Hardship withdrawals

Creating income in an early retirement (SEPP Rule)

Using a special rule in the tax code: Rule 72(t), Section 2, you can access money in your retirement plan for any reason prior to age 59 ½ as long as the distributions are “substantially equal periodic payments” (SEPP) based on one of three schedules set by the IRS.

To take advantage of this rule, there must be at least five “substantially equal periodic payments” for either five years or until you reach age 59 ½, whichever comes later.

The amount you can receive depends on a combination of your life expectancy and the amount of money in your retirement plan. The three approved IRS methods for calculation are:

  • The amortization method
  • The life expectancy method
  • The annuitization method

Each of them have the general premise that your distribution amount is the beginning of a reasonable pace of distributions where your account would last for the rest of your life. In other words, you’re not going to be able to access a large percentage of your IRA before age 59 1/2 to pay off a debt, or to buy a piece of property, but you can begin a small part of the balance each year.

For example: assume a 53 year old woman has a $500k Traditional IRA that wants to start withdrawing money early under rule 72(t). Using the amortization method, the woman would receive approximately $20,084 each year from now until she reaches age 59 ½.

Hardship Withdrawals

Regardless of your age, generally anyone can take a penalty free distribution from a retirement plan account to cover the following expenses:

  • Unreimbursed medical expenses that exceed 10% of adjusted gross income (AGI)
  • Qualified higher education expenses
  • Up to $10,000 for the purchase of your first home

Keep in mind that most retirement plans are “tax deferred” savings vehicles, so even if you avoid the penalty you’ll probably owe income tax on any withdrawals you make. *If it’s a Roth account like a Roth IRA or Roth 401k, distributions are typically tax free. Also, you can’t withdraw more than you actually need to cover the “financial hardship” that qualifies you to avoid a penalty.

For Medical Expenses

You can access money in your retirement accounts through a hardship withdrawal for any medical expenses over 10% of your AGI. Your adjusted gross income can be found on Line 11 of your IRS Form 1040 – which is your total income minus a few potential deductions.

In general you have to really be going through it to spend this much on medical expenses, but thankfully the rule on “qualified medical expenses” is pretty broad. Pretty much anything from checkups, to prescriptions, to surgeries, to eye exams fall under the rule. 

For College Expenses

You can take an IRA hardship withdrawal for qualified higher education expenses at postsecondary schools – basically anything past highschool: college, vocational schools, trade schools. And you can typically use your hardship withdrawal to pay for a wide range of expenses including: tuition, books and supplies, and even room and board.

Further, you can use this hardship withdrawal not just for yourself, but for immediate family members, so if paying for your (or your kid’s) college education is super important to you, this can be a good option.

Word of caution: taking an IRA hardship withdrawal will very likely have an impact on the student’s eligibility for financial aid. When you fill out the Free Application for Federal Student Aid (FAFSA) form, any IRA hardship withdrawals count as income to the student who is benefitting from them.

For First-Time Homebuyers

You can take an IRA hardship withdrawal for a home down payment, as long as it’s your first home and the limit doesn’t exceed $10,000. If you’re considering home ownership, but are having trouble coming down with the down payment this can be a good option.

Bottom Line

In general it’s best to let tax deferred accounts continue to be tax deferred. So even if you can avoid a penalty on retirement account contributions it doesn’t mean you should, and it almost certainly shouldn’t be your first choice. However, if it is your only choice, or if there are other tax planning considerations at work, knowing these options are great to have up your sleeve.

Resources:

Smart Asset 

Investopedia

By: David Talley, CFP®