Farrell: Taking 401(k) money before 59 ½ isn't a good idea

Q: Here’s the spot we are in. My wife had 28 ½ years in with a company and she was let go. Our goal was 30 years with the company, which would have been in September 2015, when my wife will be 55. The plan had been to tap her 401(k) (over $500,000) at that point.

First, we are wondering: Can she or can’t she at 55 start using 401(k) money without penalty? We are looking for bridges to whatever age she is allowed to take without the 10 percent penalty.

David, Hudson, Wis.

A: There are few options for tapping 401(k) money before age 59 ½ without paying the 10 percent penalty on the amount withdrawn. But more importantly, for most people, the penalty-free options that exist aren’t a good idea.

Your wife can choose to make Rule 72(t) withdrawals. She would commit to a fixed payout schedule of essentially equal sums based on her life expectancy (from the IRS tables).

She has to continue these distributions until she reaches age 59 ½ and for a minimum of 5 years, whichever comes last. Once she has passed the minimum requirement threshold, she can change her withdrawal schedule (but not before without incurring penalties). Although she won’t pay the 10 percent penalty with this strategy, the money she takes out of her 401(k) will be taxed at ordinary income tax rates.

The problem with this strategy is that it increases her risk of running down her retirement savings. It’s hard enough to save sufficient sums for a comfortable retirement without taking the money out early.

If she were older she might have come under the age-55 exemption. The rule states that if she retires, quits or is fired from her job at age 55 or over (until age 59 ½), she can start making withdrawals from her current 401(k) without penalty.

There are a couple of twists to this loophole, however. The most important is that the employer’s 401(k) plan must allow for this kind of withdrawal. The company’s plan design trumps the rule.

I think age-55 withdrawals are a bad idea for the same reasons I don’t like 72(t) distributions, even though I recognize that sometimes people have to make a financial maneuver that provides short-term relief and long-term pain.

By the way, I wouldn’t contemplate either maneuver without consulting with a professional. There is nothing simple about these withdrawal options.

It would be far better for your wife to leave the retirement savings alone and pick up even a part-time job with a slim income (or another full-time job).

Better yet, she can look for work that is both meaningful to her and offers an income, the kind of job search that typically takes time. This way, even if it turns out she can’t add to her retirement savings, at least the money in the 401(k) will continue to grow and compound.

Chris Farrell is economics editor for “Marketplace Money.” His e-mail is cfarrell@mpr.org.

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