By Dr. James M. Dahle, WCI Founder
The 10% early withdrawal penalty (sometimes called the age 59 1/2 rule) is designed to encourage investors to leave the money in their retirement accounts so that there is actually something in there when it comes time to retire. It is one of the prices that must be paid to reap the substantial tax, investing, estate planning, and asset protection benefits of tax-protected (including tax-deferred/traditional and tax-free/Roth) accounts. However, in an effort to not discourage retirement saving, the government allows many exceptions to these rules, and the 2022 Secure Act 2.0 expanded the list.
What Is the 10% Early Withdrawal Penalty?
The IRS charges a 10% penalty (in addition to any tax due) for early withdrawals from retirement accounts for which there is no valid exception. The 10% penalty applies to anyone taking money out of annuities, IRAs, SEP-IRAs, SIMPLE IRAs, SIMPLE 401(k)s, and their Roth equivalents before age 59 1/2. It also applies to anyone taking money out of 401(k)s, 403(b)s, and their Roth equivalents before age 55 and separation from the employer (or age 59 1/2 and no separation).
Thus, one great way for a mid to late 50s retiree to beat the age 59 1/2 rule is to NOT roll money out of a 401(k) or 403(b) until age 59 1/2. 457(b)s do not have early withdrawal penalties (and, thus, are often the first money spent in retirement). Health Savings Accounts (HSAs) have an age 65 rule before penalty-free withdrawals for non-healthcare expenses are permitted. Note that the HSA early withdrawal penalty is 20%, and the exceptions discussed in this post do not apply to HSAs. There is also a 10% penalty on 529 withdrawals not used for valid educational expenses. These exceptions do not apply to that penalty either. Taxable brokerage accounts, of course, provide complete flexibility but do not enjoy any of the benefits of tax-protected accounts.
More information here:
The 2023 Retirement Plan Contribution Limits
Exceptions to the 10% Early Withdrawal Penalty
There are a plethora of exceptions to this penalty. Let's go over them all and hope Congress continues to add more.
Roth Contributions
Contributions to Roth IRAs, Roth 401(k)s, Roth 403(b)s, Roth SEP-IRAs, Roth SIMPLE IRAs, and Roth SIMPLE 401(k)s can be withdrawn tax-free (and penalty-free) at any time.
Roth IRA Conversions
If Roth principal came not from a direct contribution but from a Roth conversion (like with the Backdoor Roth IRA process or the Mega Backdoor Roth IRA process), you can withdraw it penalty-free starting in the fifth year after conversion. (If you converted in 2020, you can tap the principal penalty-free starting on January 1, 2025).
Early Retirement
The 72(t) or Substantially Equal Periodic Payments (SEPP) rule allows early retirees to withdraw an actuarially reasonable amount of their retirement accounts at any age penalty-free as long as the withdrawals continue until the later of five years or age 59 1/2.
Unreimbursed Medical Expenses
Unreimbursed medical expenses > 7.5% of your adjusted gross income (which may not be that high if you're no longer working) can be withdrawn from a retirement account without penalty.
Medical Insurance Premiums
You can pay for medical insurance premiums while unemployed using retirement account money without paying any penalties. Police officers can pay up to $3,000 in premiums even if employed. Thanks to the Secure Act 2.0 and starting in 2022, those police payments do not even have to be made directly.
Death
If you die, your heirs can withdraw from your account (now an inherited IRA) without penalty. Note that if your spouse elects to roll your account into their own account, a penalty could apply.
Disability
If you become permanently disabled, you can withdraw from your retirement account without penalty.
Qualified Higher Education Expenses
You can use retirement account money to pay for your own education, that of your children, or that of your grandchildren without penalty.
A First Home
You can also use up to $10,000 of retirement account money ($10,000 of earnings for Roth accounts) for the purchase of a new home for you, your children, or your grandchildren as often as once every two years without paying the 10% penalty.
New Child (Including Adoption)
Starting in 2020, if you have a child or adopt a child, you can withdraw up to $5,000 from a retirement account penalty-free.
IRS Levy
If the IRS places a levy on you, you can use retirement account money to satisfy it without penalty.
Reservist Distribution
A reservist called to active duty for at least 180 days can withdraw money penalty-free as well.
Hardship Withdrawals
Hardship withdrawals became much more common during the COVID pandemic. The Secure Act 2.0 allows investors to self-certify their own hardship. It also made permanent the ability to withdraw up to $1,000 from a retirement plan once per year without penalty. You can even pay it back into the plan once you recover from the hardship. If you choose not to, you cannot take out another withdrawal for three years.
Firefighter Exception
The age 55 rule is the age 50 rule for firefighters. Thanks to the Secure Act 2.0, that applies to private firefighters, too.
Police and Corrections Officer Exception
Thanks to the Secure Act 2.0, police and corrections officers can now benefit from the age 50 rule. In fact, they don't even have to wait until age 50 if they've put in 25 years of service.
Domestic Abuse
Thanks to the Secure Act 2.0 and starting in 2024, victims of domestic abuse can withdraw the lesser of $10,000 or 50% of the balance and repay it for up to three years (with a refund of any taxes paid on the withdrawal).
Terminal Illness
Thanks to the Secure Act 2.0 and starting in 2022, terminal illness is now another valid exception to the 10% early withdrawal penalty. Terminal illness is a pretty vague term (we're all terminal, really), but I presume a stricter definition will be forthcoming soon. Otherwise, the current definition seems to be “a medical condition that is untreatable and expected to result in death.” I assume you'll need a doctor besides yourself to sign off on that.
Natural Disaster
Thanks to the Secure Act 2.0 and starting on January 26, 2021 (retroactive), if you are the victim of a natural disaster, you can withdraw up to $22,000 from your retirement accounts without penalty and spread the taxes due out over three years. You can pay the money back into your retirement account, too (and get a refund on the taxes paid). You can also repay any money you took out of retirement accounts to buy a first home if you are the victim of a disaster.
Long-Term Care Insurance Premiums
Thanks to the Secure Act 2.0 and starting in 2026, you can withdraw up to $2,500 per year to pay long-term care insurance premiums without paying the 10% penalty.
More information here:
Comparing 14 Types of Retirement Accounts
Fungibility
Given all of these exceptions, there is likely to be something that you are doing with your money (or that your kids or grandkids are doing with their money) that qualifies as an exception. Money is fungible, and anyone can gift anyone else up to $17,000 per year tax-free (an increase from $16,000 in 2022) without filing a gift tax return. So, if your kid gives you $10,000 to spend and you use $10,000 in your retirement account to pay for that kid's new house, there is no 10% penalty.
Or maybe your grandkid is in college. Now, your kid can give you (and your spouse) $17,000 each and you can use $34,000 from your retirement account for that grandkid's tuition.
Likewise, say you paid out of pocket for long-term care premiums and some health insurance premiums while you were unemployed earlier this year but now want to pull some more money out of your retirement account to buy a little boat. No problem. You can justify a withdrawal up to the amount of the valid exceptions.
Money is fungible, and creativity may open a path you may not have considered.
As you can see, there are a plethora of exceptions to the 10% early withdrawal penalty. There are so many that it should not be a particularly useful excuse to save for retirement outside of a retirement account. Even for an early retiree.
What do you think? Which exceptions have you or will you take advantage of? Does the Secure Act 2.0 help you in this regard? What other creative ways have you thought of to take advantage of these exceptions? Comment below!
Question about MegaBackDoor Roth:
My company matches approx 4.5% for our 401K. THey do it evenly throughout the year so they recommend even contributions throughout the year and not to frontload or you will not get the full match then. They allow contributions beyond the $22,500. So I could go up to $66,000. THey told me I can convert the post-tax money to a Roth (has to be sent to a Roth outside their institution though; I already have my backdoor Roth at TD AMeritrade). However only unmatched money can be used for ROth conversion.
How do I make sure my post-tax contributions are not matched?
Thanks,
Maha
So ask HR exactly how you have to do the contributions to get the full match and also hit the $66K limit. This isn’t an IRS thing, it’s a plan thing.
Let’s say you make $330K and get 4.5% of that matched. That’s $14,850. So $66,000-$14,850 = $51,150. $51,150/12 = $4,262.50. That’s what I’d put into the plan each month. Then once a year I’d do a Roth conversion into your Roth IRA at TD Ameritrade.
You mentIoned “age 55 and separation from the employer .”
Since I’m 55 I can leave my job and access my 401k right away. That rule of 55“ may deserve its own header.
That’s a pretty picky criticism. “You said it but not in big enough font.” 🙂
HA!
Fair enough.
I guess font size becomes important when you’re 55.
I found it became very important at 45. Now I have to wear readers to suture.
If I have regular Roth contributions (from when my income was lower), Backdoor Roth, Mega Backdoor Roth, the principal, and the earnings all mixed up in one Roth IRA, what should I know when it comes to early withdrawals? Aren’t all withdrawals considered to be pro rated between principle and earnings or something?
First comes out contributions (principal).
Then comes out converted amounts (principal).
Then comes out earnings (taxable earnings).
Ah, thank you.
Great succinct answer. I had the same question a while back.
To add a bit further detail for early withdrawals, I believe you won’t pay any taxes or penalties for any original contributions, or rollovers at least 5 years old (and the IRS will “deduct” from the oldest to the newest conversions, to ensure you will tap those oldest rollovers first). Then you’ll pay a 10% penalty on any rollovers less than 5 years old, but no taxes (i.e. that won’t be added to your standard income) (I’m 80% sure about that, since you’ve already paid taxes on those rollovers). Then you’ll pay a 10% penalty PLUS pay taxes (i.e. add to your standard income) any earnings that are left in the account.
And of course you have to make sure it’s been at least 5 years since you first contributed to any Roth – which most folks have.
Lots of people confused about those two 5 year rules.
There is a 5 year rule for conversions which determines whether the principal can be withdrawn penalty free. However, there are exceptions (see list in the post but this list includes being 59 1/2, it’s “either/or”.)
There is also a 5 year rule for Roth IRA contributions which determines whether earnings can come out tax-free. This one is in addition to the other rules so it’s not”either/or”, it’s “both.” But it’s from the time the first contribution to that account was made.
I have read that you can take a “loan” from a Roth IRA in certain situations and pay it back within 60 days. I am moving jobs and states and plan to sell my home and buy another home. In the event I cannot sell my home prior to my new home purchase have you heard of people taking money out of their Roth IRA to make a down payment and then pay it back once their home closes?
You’re talking about a rollover where you actually take possession of the money which can be done once a year and you have 60 days to get it into the new account. Too risky IMHO. I wouldn’t do it. What if the second home doesn’t close in time?
This is really helpful, thanks.
If I understand re: qualified higher education expenses…
I had envisioned a scenario late 50s in which we could potentially coastFIRE (or pick acronym) in which I *could* go from 1.0 FTE down to 0.6 or 0.7 FTE (minimum needed to get health benefits) if I wanted. We would have nice nest egg by then, so plan would be to pull back retirement contributions to 401K given lower salary at part-time but concern was losing auto match (1:1 up to 6% by employer). However, NOW I figure less of issue as I would still make contributions, and then just turn around and pull money right back out and pay for (some of) kids’ college tuitions on the fly (and still get employer match) since no penalty. In fact, this would change calculation now and further support ideas you’ve made before why not to have 529 fully funded. IE I might even decrease 529 contributions now. Am I thinking of this right?
Cool trick!