Can you withdrawal money from your 401(k) while you are still employed? Not everyone should, not everyone can, however, if you can, it may mean that you can effectively implement part of your retirement income plan before you retire.

If your 401(k) plan permits it, you can take an in-service withdrawal from your 401k and redirect some of your money into another investment vehicle that offers income guarantees. The reasons why: A non-hardship withdrawal can provide you with early access to a portion of your retirement assets, freeing you to manage them as you wish. If the mix of funds in your 401(k) have taken a big hit lately, you might be wondering how some of those assets would do if they were invested differently.

The self-directed IRA option.

Some people are withdrawing assets from qualified retirement plans such as 401(k)s, and place them in self-directed IRAs. A self-directed IRA can allow you to invest your assets in real estate, commodities and other sectors indirectly correlated or uncorrelated to stocks. While many kinds of IRAs can be converted to self-directed IRAs, you need to have an IRA custodian that will allow a self-directed IRA and let you make non-traditional investments using IRA assets.

Typically, the IRA custodian has to be a registered trust company. You can then take a self-directed IRA one step further and set up an IRA LLC. With an IRA LLC, you have a checkbook control and don’t need your IRA custodian’s approval to make a non-traditional investments.

Many self-directed IRA owners invest in income property or other forms of real estate. Contrary to public perception, IRA assets may be invested in real estate and other options besides securities, providing your IRA custodian allows this.

There are some notable prohibitions. IRS code, section 401IRC 408 Section A3 prohibits life insurance contracts from being held in IRAs and IRS publication 590 states that your traditional IRA will be hit with additional taxes if you invest in collectibles such as coins or fine art.

The 72-T strategy to avoid the early withdrawal penalty.

If you are still working and pull money out of your 401(k) before 59.5, you will almost certainly pay a 10% early withdrawal penalty plus income taxes on the money that you take out. You might be able to make early withdrawals with the help of IRS rule 72T. Rule 72T, based on life expectancy let’s you schedule fixed income withdrawals for five years or until you reach 59.5, whichever is longer. It let’s you receive six equal payments according to IRS calculations.

First thing is first to make sure that you can do this. Talk with your employer benefits officer at work and see if that is the summary plan description permits non-hardship in-service withdrawals.

If you know you will need more retirement income, there may be real merit to reinvesting early withdrawals from 401(k) in vehicles that generate it.

photo credit: {Guerrilla Futures | Jason Tester}

Having some talks with Papa Boomer about early retirement, I learned that he implemented a strategy called “72(t)” distributions.  I just assumed that meant that he was having a midlife crisis and was going to by that 72 Thunderbird that he always wanted.  Then I learned that this is a early retirement strategy that many implement to get access to their retirement funds before the age of 60.  After some research, this is what I found out….

So what is 72(t) you ask?

Typically, if you withdraw monies out of your retirement plan before you reach the age of 59 ½, you are assessed a 10% penalty on the top of ordinary income tax. One exception (others include: first-time home purchase, college tuition payments, disability) to that is a 72(t) distribution that is a “substantially equal periodic payments”.

How Does the IRS Consider 72(t)?

Let me explain further. To determine your “substantially equal periodic payments”, you must use one of the three methods that the IRS has determined and then take your payment on a set schedule for a specific time period. It is required that you take those payments for either 5 years or when you turn 59 1/2 , whichever comes later. For example, if you start taking your payments at the age of 52, then you must do so for 8 years. Someone who starts at 57, must do so till the age of 62.

Determining if 72(t) is right for you.

If you start the 72(t) distributions and then decide later to stop them before the period is expired, you are assessed a very hefty penalty. You will be taxes the 10% penalty plus interest for every payment that you received. So for the 52 year old that decides at 58 to stop, they will go back 6 years and assess the penalty. What will also trigger the penalty if you are forced to take an additional payment from your retirement plan. So if you start the equal periodic payment and then a financial emergency that does not meet one of the exceptions arises and you are forced to take more money out, you will pay the penalty. This can be a very tax efficient planning strategy when used correctly.

Jeff Rose over at Good Financial Cents has some alternatives that one can explore if 72(t) does not work for you. I would definitely advise talking with a financial planner before implementing this strategy.