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In a follow-up, nid asks:

I plan to retire at 50. How do I start withdrawing from my 401K without getting nailed with a penalty tax.

I understand there is a method where you can withdraw a certain level amount over a specified period of time before age 59 and avoid the penalty tax. If my annual 401K returns match that annual withdrawal amount is it possible to only be withdrawing the gains and at the end of the specified period still have the original principle in the 401K?

See the link on Section 72(t) withdrawals provided earlier. If you use the annuity or amortization methods and if your portfolio has significant growth, then in theory you could be taking income just equal to the earnings. However, much depends on the method of withdrawal you choose because that method results in "substantially equal periodic payments" based on your life expectancy when the withdrawals begin. Whatever the computation says must be taken is what (I>must be taken to avoid the early withdrawal penalty. That amount may be more or less than the income the portfolio itself produces.

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