In an ideal world, everyone would leave their retirement savings untouched until they retired. However, we live in the real world, and sometimes you need to dip into your nest egg early. In fact, nearly a third of Americans who participate in a 401(k) plan have taken money out at some point before retirement, according to a 2014 study from financial services firm TIAA-CREF.
The problem is that taking money from your 401(k) or traditional IRA can be costly. The IRS imposes a 10% early distribution penalty on money you withdraw before you reach age 59 1/2, and you're also subject to income taxes on the money you take out (unless you're withdrawing from a Roth 401(k) account). For small withdrawals, these costs may not be too burdensome. But if you need tens of thousands of dollars, the penalty alone can drain your bank account.
Continue Reading Below
However, there are ways to take money from your tax-advantaged savings account without facing a penalty. The easiest is to simply wait until you turn 59 1/2, but if you don't have that kind of time, there are other options.
Why withdrawing from your retirement savings should be a last resort
First, it's important to note that while you can withdraw your funds from a 401(k) or IRA penalty-free, it doesn't necessarily mean you should. Even if you withdraw a relatively small amount, it can have a significant impact on your long-term savings goals.
For example, let's say you currently have $50,000 in your 401(k), you're contributing $100 per month, and you're earning a 7% annual rate of return on your investments. Here's how withdrawing $5,000 from your 401(k) would affect your savings over time, assuming you continued to contribute $100 per month:
In other words, that $5,000 withdrawal would cost you nearly $40,000 over 30 years, and that's not including any penalties or income taxes you may need to pay.
That being said, if you've weighed all your options and decided you need to withdraw money from your 401(k) or IRA, there are a few situations in which the penalty is waived. Keep in mind that only the penalty is waived -- not the income tax. However, avoiding the 10% fee can soften the blow to your wallet.
1. Buying your first house
If you're buying your first house, you can withdraw up to $10,000 for a down payment without paying the 10% penalty. Unfortunately, 401(k) withdrawals are not eligible for penalty-free withdrawals for homebuyers, but you can withdraw money from an IRA without facing any fees.
With an IRA withdrawal, the maximum lifetime withdrawal limit for homebuyers is $10,000, and while you don't necessarily have to be a first-time homebuyer, you cannot have owned a home during the last two years. If you don't have an IRA, you can roll over money from a 401(k) into an IRA to get around the penalty. But because you can't roll over funds from your current employer, it will need to be a 401(k) from a former employer.
If that's not an option for you, you can borrow from your 401(k) instead. You can take a loan of up to $50,000 or half of the vested balance of your 401(k), whichever is less (unless half of the vested account balance totals less than $10,000, in which case you can borrow up to $10,000). Most employers require that you pay the loan back within five years, and if you leave your job before the loan is paid off, you'll likely need to pay it in full within 60 to 90 days of leaving. Finally, you will need to pay interest on the loan, but that money is deposited back into your account.
2. Paying for certain medical expenses
Medical bills are costly, and not everything is covered by insurance. Fortunately, if you're faced with a high bill that insurance won't cover, you can use some of your 401(k) or IRA funds to pay for it penalty-free.
There's a catch to this, though: The penalty is only waived for expenses that exceed 10% of your adjusted gross income and aren't covered by insurance. In addition, you have to make the withdrawal in the same year that the medical expenses were incurred to avoid paying the 10% penalty.
3. Paying for health insurance premiums
Even if you're unemployed, you shouldn't forgo health insurance. The average cost of a routine adult physical examination is about $200 without insurance, according to Blue Cross Blue Shield, and more expensive medical expenses, such as an emergency room visit or MRI, can cost thousands.
After you've been unemployed for at least 12 weeks, you're eligible to withdraw 401(k) or IRA funds penalty-free to pay for health insurance premiums. If you have a spouse or dependents, you can use those withdrawals to pay insurance premiums for them as well.
4. Paying for college
As with buying a home, 401(k) withdrawals used for college expenses are subject to the 10% penalty fee. However, in an IRA, there's no penalty on distributions for qualified higher-education costs.
You can withdraw the full amount of your qualifying higher-education expenses from an IRA. The money doesn't just have to go toward your own college costs, either; it can also cover the expenses of your spouse, child, or grandchild. Qualifying expenses include tuition, fees, books, supplies, room and board, and more.
Taking money from your retirement fund should never be your first resort, but it's a possibility if you have no other options. While you'll need to work a little harder to catch up on your savings after making a withdrawal, avoiding the 10% penalty can help ensure those withdrawals won't derail your retirement goals.
The $16,122 Social Security bonus most retirees completely overlook If you're like most Americans, you're a few years (or more) behind on your retirement savings. But a handful of little-known "Social Security secrets" could help ensure a boost in your retirement income. For example: one easy trick could pay you as much as $16,122 more... each year! Once you learn how to maximize your Social Security benefits, we think you could retire confidently with the peace of mind we're all after. Simply click here to discover how to learn more about these strategies.
The Motley Fool has a disclosure policy.
Continue Reading Below