The most common retirement plan we use as Americans is the 401k plan… and why wouldn’t it be? At this point, when you start a new job, you are automatically enrolled and you have to opt out if you don’t want it.
I personally don’t have a 401k, and don’t really like them. There are a lot of 401k alternatives that to me make more sense. That being said, I want to show you how and why it might make sense to do what I call, the 401k early withdrawal technique… and yes, I just made that up.
There is nothing excessively tricky or special here, just a few gems most people are not aware of – including financial advisors. There are a few occasions where it might not only make sense to withdraw your 401k early (before age 59 1/2), but you can also avoid the penalty (typically 10%), normally associated with doing so.
401k Early Withdrawal Options
First and foremost, 401k plans typically have a wide variety of limitations, and each plan has its own rules. So first and foremost, if you want to withdraw money there are usually two barriers to doing so. And I don’t just mean without being penalized, I mean you cannot withdraw any 401k money period.
You have to fall into one of these two categories:
1. Your 401k provider will allow a transfer of 401k funds (few plans allow this).
2. You no longer work for the company that controls your 401k.
And the first is a rare category.
If you do fall into one of these categories, or plan to, here are your options for a 401k withdrawal.
401k Early Withdrawal – No Penalty – While few people have ever heard of this little gem, IRS Rule 72t allows you to take money out of your retirement account early, without penalty, before 59 1/2. The rule is withdrawals need to be systematic, or consistent. There are calculators you can use to determine how much you could withdraw from your 401k.
401k Full withdrawal – With Penalty – While taking a full withdrawal is not always the ideal situation, it can often make sense, and it’s all based on income. Here are two scenarios to think about.
1. If you have low income over the course of a year, you could take a 401k withdrawal, and the penalty plus the low tax bracket would be the similar to your working years. Meaning, if you drop from a 25% tax bracket to a 15% tax bracket and do a 401k withdrawal, then the penalty (10%) plus the tax bracket would equal the same tax bracket you were in before.
2. If you are young and have 401k money, you may save yourself taxes by withdrawing today and converting it to something tax free like a Roth IRA, a high cash value life insurance policy, or something like the Infinite Banking Strategy. The same math applies here. If you are in a 15% bracket today, but will be in a 33% bracket in retirement (or possibly more), then taking the penalty today on a 401k early withdrawal would ultimately save you down the road.
Now these are delicate… you’ll want to consult with a tax advisor, but just because that money is currently locked up, doesn’t mean you are without options.
Photo Credit: Flickr – Tax Credit