Retirement benefits often have complicated rules, and it's easy to trigger fees. However, those who carefully follow the rules will be able to accumulate a bigger retirement account balance and get more money from Social Security. Here are some retirement penalties you can avoid with careful planning.
401(k) and IRA early withdrawal penalties. There's a 10 percent early withdrawal penalty for IRA distributions before age 59 1/2 and 401(k) distributions before age 55. The penalty is applied in addition to the regular income tax due on the withdrawal. However, there are a variety of ways around the penalty, even for people who need access to their money early. For example, a 401(k) loan allows eligible employees to borrow up to 50 percent of their vested account balance up to $50,000 without penalties or tax consequences, but watch out for loan fees and the loan becoming due if you leave your job.
There are several exceptions to the IRA early withdrawal penalty. The penalty doesn't apply if you use the money for specific purposes, such as large medical bills, health insurance after a layoff, college costs or a first home purchase. Those who set up regular annuity payments from the account over their life expectancy will not be charged the 10 percent penalty. "One option would be the 72t distribution, where you can withdraw money from an IRA if you withdraw a consistent amount each year for five years or until you reach 59 1/2, whichever is later," says Ross Menke, a certified financial planner and founder of Lyndale Financial in Nashville, Tennessee. Specific groups of people also have options to avoid the penalty, such as those who are disabled and members of the military reserves on active duty.
Roth accounts allow more flexibility for people who might need access to their money early. Roth IRA owners can take an early withdrawal without being subject to a penalty as long as they don't withdraw more than the amount contributed to the account. Roth 401(k) early withdrawals are prorated between contributions and investment earnings, so the portion of an early Roth 401(k) distribution that comes from investment earnings is likely to be taxable.
The penalty for skipping a required minimum distribution. Annual withdrawals from traditional retirement accounts are required after age 70 1/2. "For those 70 1/2 and older, RMDs must be taken from traditional 401(k) plans and traditional IRAs by December 31, and income tax is due on each withdrawal. The penalty for missing a required minimum distribution is steep at 50 percent of the amount that should have been withdrawn, and that is on top of the income tax due," says Ajay Kaisth, a certified financial planner for KAI Advisors in Princeton Junction, New Jersey. "There is an exception for Roth IRAs; no RMDs are required. However, a Roth 401(k) account is subject to the RMD requirement." Retirees age 70 1/2 or older who donate an IRA distribution directly to a qualifying charity can satisfy their minimum distribution requirement without owing income tax on the transaction.
Social Security early enrollment penalty. You can start your Social Security payments as early as age 62, but your payments are reduced if you sign up before your full retirement age, which is typically age 66 or 67. If you begin collecting benefits at age 62 you will get 25 percent smaller monthly payments if your full retirement age is 66 and 30 percent smaller payments if your full retirement age is 67. Those who signed up for Social Security early and then regret it have a couple of options to get bigger payments. If you change your mind within 12 months of starting your benefit, you can repay all the money you received, withdraw your Social Security application and then apply for higher payments later. If you are between your full retirement age and age 70 you can temporarily suspend your Social Security payments, which allows you to earn delayed retirement credits that will increase your Social Security benefit by 8 percent for each year of suspension before age 70. Continuing to work in retirement can also increase your Social Security payments if you earn more now than you did earlier in your career. "The amount that you are going to receive in Social Security payments in the future is calculated off your highest 35 years of income," Menke says. "If you did have some zero income years, working longer will have an effect on what your actual benefit will be in years to come."
Medicare late enrollment penalties. It's important to sign up for Medicare when you are first eligible to do so, beginning three months before your 65th birthday or within eight months of leaving a job with group health coverage. If you sign up later, Medicare Part B premiums increase by 10 percent for each 12-month period you delayed enrolling in Medicare after becoming eligible for benefits. The Medicare Part D penalty begins if you go just 63 days without prescription drug coverage after becoming eligible for Medicare and increases the longer you go without coverage. The penalty is added to the premium for any Medicare Part D plan you select. And you only have a right to buy a Medigap policy during the six-month period when you are 65 or older and enrolled in Medicare Part B. After that, private insurance companies can charge you significantly higher premiums or even deny you a policy. Failing to sign up for the various parts of Medicare during the months around your 65 th birthday can result in significantly higher premiums for the rest of your life.
Excessive expense ratios. While you can't control how your investments perform, you do have a measure of control over how much you pay in fees and other investment costs. However, a recent Pew Charitable Trusts survey of nearly 3,000 private sector workers found that about a third aren't familiar with the fees they are charged in their retirement account. 401(k) plan sponsors are required to provide fee information about each investment option to plan participants. Take the time to compare the expense ratios of each fund in your 401(k) plan and aim to select the funds with the lowest costs that meet your investment needs. "Saving and investment returns compound over time, but we don't really talk about how fees can compound over time," says John Scott, director of the The Pew Charitable Trust's retirement savings project. "It's always a good idea to compare investment alternatives, including on fees."
Emily Brandon is the author of "Pensionless: The 10-Step Solution for a Stress-Free Retirement."