Not all employers permit early 401(k) withdrawal. To this end, you must check with the head of your HR to see if this option is open to you. That being said, you must note that early 401(k) withdrawal attracts a penalty tax. The IRS has a penalty for withdrawing funds from your 401(k) plan before the age of 59½. However, with some qualified exceptions, you can duck the penalty.
Early Withdrawal Penalty & Exceptions
Traditionally, the eligible age to withdraw funds from the 401(k) is 59½. However, you can withdraw from the 401(k) plan before age 59½ but with a 10% penalty tax.
However, the IRS allows you to take funds from the 401(k) plan without the 10% penalty tax on the condition that one of the withdrawal methods is a Subsequentially Equal Period Payment (SEPP), among other methods. SEPP is a means for IRA holders to take funds from the 401(k) plan without the 10% tax penalty. In addition, this method is a suitable option if your financial need is long-term.
The IRS offers three Subsequentially Equal Period Payment (SEPP) options to take advantage of, including;
- Taking your distribution as a Required Minimum Distribution (RMD).
- Taking your distribution as a Fixed Annuitization.
- Taking your distribution as a Fixed Amortization.
In this post, we shall focus on the Fixed Amortization method since the IRS recently made some changes.
What is the Fixed Amortization Method?
The fixed amortization method is a penalty-free method that allows you to take funds from your 401(k) plan before retirement. However, taxpayers must have in mind that they still need to pay tax on this amount. In other words, it is still subject to ordinary income tax. Furthermore, it is with the condition it must be withdrawn and paid equally with the same amount each month. With this, you can take funds from the 401(k) plan without the 10% penalty.
Until recently, when the IRS made changes to the fixed amortization method, the rate used to be at 1.52%. Now, it is at 5%. In addition, the fixed amortization method requires you to continually withdraw your funds at the same amount for 5 years or until you are 59½ years old, whichever is later. If you do not, you will be subject to the penalty tax. However, there is an exception to the fixed amortization continuous withdrawal method.
There is a one-time offer to switch from the fixed amortization method to the required minimum distribution (RMD). But this comes with the disadvantage that the RMD has a significantly lesser monthly payment.
Let’s look at Jill. She is 50 years old, divorced, and with a $1m 401(k) account balance. She wants to withdraw using the fixed amortization method. When it was at 1.52% rate, she’d be able to take only $36,000 per year from her 401(k) penalty-free every year. Now the rate has been increased to 5%; she can get as much as $60,000 from her 401(k) penalty-free annually even if she is not up to 59½ years old. Regardless, she is still subject to the ordinary income tax. Meaning she has to pay tax on the amount she receives.
However, she has to take the amount till she becomes 59½ years old or 5 years from when she made the first withdrawal, whichever comes later. If Mary stops the payment before the stated time, she becomes subject to the 10% penalty tax on all prior payments as well as future payments.
It is best not to run out of retirement funds before one runs out of time. To this end, it is of utmost importance to proceed with caution. We recommend this method for immediate and urgent financial needs. This method is also suitable for individuals who want to retire for a few years before starting something new. Lastly, we recommend you sit with your financial advisor and your tax advisor to determine which method gives you the best tax advantage.