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Piershale: Avoiding penalties on company retirement plans

You’ve probably heard that if you withdraw taxable amounts from your 401(k) or 403b plan before age 59 ½ , you will be hit with a 10 percent early distribution penalty tax on top of the federal income tax you'll be required to pay. But the IRS code contains exceptions that allow you to take penalty free withdrawals before age 59 and a half.

If you’ve reached age 55, you can take penalty free withdrawals from your 401(k) plan after leaving your job if your employment ends during or after the year you reach age 55. For example, if someone retires at age 55 and wants to pay off their mortgage with part of their 401k plan they can do it without triggering a 10 percent penalty.

And if you're a qualified public safety employee like a policeman, a fireman, or an emergency medical technician, this exception applies if you’ve separated from service in or after the year you attained age 50. 

Another important exception to the penalty tax applies to 72-T’s, better known as "substantially equal periodic payments." This exception also applies only after you've stopped working for the employer that sponsored the plan. To take advantage of this exception, you must withdraw funds from your plan at least annually based on one of three IRS approved distribution methods. This could be a great option for somebody who retires before 59 ½ and wants to take a monthly income from their company retirement plan. If they set it up as a 72-T they could take income at any age without a 10 percent penalty.

Regardless of which method you choose when using a 72-T, you generally can't change or alter the payments for five years or until you reach age 59 and a half, whichever occurs later. If you do modify the payments, you'll wind up having to pay the 10 percent penalty tax on the taxable portion of all your pre age 59 and a half distributions.
 
Distributions for unreimbursed medical expenses, that exceed 10 percent of your adjusted gross income for the year, are not subject to the 10 percent penalty. This is true even if you don’t itemize deductions.

Distributions made as a result of a qualifying disability also escape this 10 percent penalty. This means you must be unable to engage in any "substantial gainful activity" by reason of a medically determinable physical or mental impairment.

Distributions also avoid this penalty if made to qualified military reservists called to active duty; paid pursuant to a qualified domestic relations order in a divorce, and made to your beneficiary after your death, regardless of your beneficiaries’ age. 

Remember that the exceptions applicable to IRAs are similar to but not identical to the rules that apply to company retirement plans.

• Mike Piershale, is president of Piershale Financial Group. If you have financial questions on this column contact us at Piershale Financial Group, Inc., 407 Congress Parkway, Crystal Lake, IL 60014. You may also email mike@piershalefinancial.com.

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