You’ve probably heard the advice: “Don’t contribute to your 401(k) because that money will be locked away until you’re at least 59.5.” While this is commonly said, it’s not entirely accurate, and often it’s from people promoting other financial products. Let’s clear up the confusion and explain why this statement is misleading.
A 401(k) is a pre-tax retirement account. This means that contributions reduce your taxable income today, and taxes are paid when you withdraw the funds during retirement. The growth of your investment is tax-deferred, so you don’t pay taxes on it until you make withdrawals.
Many 401(k) plans also include an employer match. For instance, your employer might offer to match 100% of your contributions up to 3% of your salary. That means for every dollar you contribute, your employer contributes an additional dollar—free money, right?
Additionally, most 401(k) plans offer a Roth 401(k) option, where you contribute after-tax dollars, and your withdrawals in retirement are tax-free.
Despite these benefits, many people avoid contributing to their 401(k) because they fear their money is “locked up” until they’re 59.5. But that fear often stems from misunderstanding the rules. The truth is, there are ways to access your 401(k) funds before that age without incurring a 10% early withdrawal penalty, thanks to a provision in the tax code called Rule 72(t).
What Is Rule 72(t)?
Rule 72(t) is part of the Internal Revenue Code that allows early withdrawals from certain retirement accounts, such as 401(k)s, without the typical penalty. This rule permits early withdrawals under specific conditions, such as for medical expenses, a first-time home purchase, college tuition, or if you’re permanently disabled. But if none of these apply, Rule 72(t) allows you to withdraw funds without the 10% penalty.
Under Rule 72(t), you can set up Substantially Equal Periodic Payments (SEPPs). These are a series of equal payments made annually (or more frequently) from your retirement account, which can continue for five years or until you reach 59.5, whichever is longer.
Note: If you begin taking SEPPs before 59.5, you must continue the withdrawals into your 60s, even if you’ve already reached 59.5 by the time you complete the required five years.
Key Rules to Follow for Rule 72(t)
- Schedule Annual Withdrawals at Minimum You are required to take at least one SEPP each year for five years, or until you turn 59.5, whichever is longer. If you miss even one scheduled payment, you will face penalties on all previous withdrawals under this plan.
- Pay Income Taxes on Withdrawn Funds Since contributions to a 401(k) are made with pre-tax dollars, any money you withdraw is subject to income tax. This includes both contributions and any earnings in your account.
- No Withdrawals From Accounts at Your Current Employer If you are still employed with the company managing your 401(k), you cannot use Rule 72(t) for withdrawals. This rule only applies to retirement accounts you’ve already set up and contributed to from previous jobs.
Proceed with Caution
Rule 72(t) can be a useful tool for accessing your retirement funds early, but it comes with potential pitfalls. If you make any errors in implementing the strategy, you could face a 10% penalty on the funds you’ve withdrawn. It’s crucial to fully understand the rules and make sure everything is done correctly, which is why working with a financial advisor is recommended.
Navigating the complexities of Rule 72(t) and setting up the correct withdrawal schedule can be challenging, so having professional guidance can help ensure that you avoid costly mistakes.
