When You Can Tap a 401(k) Early With No Penalty

The general rule for tapping a 401(k) free of the 10% early-withdrawal penalty is that you must be at least age 59 1/2. But as with many rules, there is an exception. Leave your employer in the year you turn 55 or older and Uncle Sam cuts you some slack: The early-withdrawal penalty disappears early.

You will still owe tax on the withdrawal. A $10,000 payout at a 25% tax rate will cost you $2,500 -- but you'll avoid a $1,000 early-withdrawal penalty.

How you separate from service doesn't matter. Retiring, being laid off or even getting fired all qualify. As long as you are 55 by the end of the year you leave the job, the rule applies. Leave your job in January and turn 55 in December, for example, and 401(k) payouts anytime during the year are penalty-free, says Jeffrey Levine, chief retirement strategist for Ed Slott and Co. Retire in December and turn 55 the following January, though, and you're stuck with the penalty until 59 1/2.

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Reaching 55 or older in the year you leave is the key, not simply your 55th birthday. If you left a job at age 50, for example, you can't tap that 401(k) penalty-free until you reach age 59 1/2.

But say you leave an employer at age 55 to work for another company, and then depart that job at age 57. You could tap both 401(k)s penalty-free -- because you left both companies in the year you turned 55 or older.

This exception is handy for early retirees who need to tap their 401(k) for living expenses. But beware that you can blow this break if you roll over your 401(k) to an IRA. Once the money is in the IRA, age 59 1/2 becomes the earliest age for penalty-free withdrawals.

An IRA, though, has more investment choices than a 401(k)'s limited investment menu. Levine says that splitting the 401(k) could give you "the best of both worlds." Say you retire at 55 with $1 million in your 401(k), and you want to withdraw $50,000 annually for the next five years. You could leave $250,000 in the 401(k) to tap penalty-free, he says, and roll $750,000 into an IRA to take advantage of other investment choices.

One potential obstacle to the split strategy: your 401(k) plan's rules. Some plans don't allow partial withdrawals, and some don't allow periodic distributions. Ask your benefits manager for the details of what your 401(k) allows.