When you deposit into your 401(k), you’re putting that money away for the future. But what happens if you need that cash now?
The good news: You can access your 401(k) funds before you turn 59 ½, the IRA retirement age, through a process the IRS calls an “early withdrawal.” The bad news: An early withdrawal usually triggers a steep penalty in addition to taxes. You will also lose out on years of potential growth for your nest egg.
However, there are exceptions to the rules — and strategies to avoid such dire consequences.
401(k) early withdrawal penalty
A 401(k) is an employer-sponsored retirement plan. You make regular pre-tax contributions to it – that is, straight off the top of your paycheck — and the money within it grows tax-free.
Because these tax-advantaged accounts are meant to help you save for retirement, the IRS imposes strict rules about when and how you can withdraw your money. Primarily, you have to be at least 59 years and six months old.
Technically, anyone can withdraw funds at any time — or take a distribution, in IRS-speak — from their 401(k) before they hit that magic age. It’s your money, after all.
But you may not get as much money as you had hoped for. That’s because the withdrawal will be subject to:
- A mandatory 20% federal tax: When you take out money, the plan’s service provider is required to withhold 20% in federal income tax. That means if you withdraw $10,000, you will get $8,000. While you will get this back as a tax refund if the money withheld exceeds your tax liabilities, this will significantly cut into the money that, presumably, you need immediately.
- A 10% tax penalty: You will owe a 10% penalty when you file your income tax return — or $1,000 on that $10,000 withdrawal.
A 401(k) early withdrawal will cost you more than just 30% off your withdrawal. Something that could be even worse — in the long run, at least — is the missed opportunity for that money to grow in your account.
For example, say you withdraw $20,000 when you’re 40 years old. Assuming a 7% annual rate of return, the potential future value of that $20,000 today would be nearly $110,000 by the time you’re 65.
Exceptions to the 401(k) early withdrawal tax penalty
In most cases, you’ll just have to take that 10% penalty if you decide to withdraw from a 401(k). But the IRS will waive that 10% penalty in extenuating circumstances:
- You become or are permanently disabled: If you are or become disabled for life, you won’t owe the penalty.
- You are dividing assets in a divorce: Withdrawals made to satisfy a court order to divvy up the 401(k) with a former spouse or dependent are penalty-exempt.
- You are a qualified military reservist: You can take penalty-free withdrawals during your service period if you’re called to active duty for at least 180 days.
- You leave your job at age 55: Also known as the rule of 55, this provision allows anyone who retires, quits, or is fired at age 55 to withdraw without penalty.
- You enroll in “substantially equal periodic payments”: With SEPP, you withdraw a specific amount from your 401(k) every year for five years or until you turn 59 ½, whichever comes later. One catch: This account can’t be the one you have at your current job — it has to be one you’ve kept from a previous employer. Also, if you quit the SEPP plan early, you’ll owe all the penalties, plus interest.
In addition to these events and situations, there are two other main ways to cash out early without a tax penalty: hardship withdrawals and loans.
How 401(k) hardship withdrawals work
The IRS allows anyone to take penalty-free withdrawals if they have an “immediate and heavy financial need.” You can use the money to cover your needs or those of someone else.
You may qualify for a hardship distribution if the funds go to:
- Pay for certain medical expenses
- Buy a primary residence (excluding mortgage payments)
- Cover college tuition, fees, room, and board
- Prevent eviction or foreclosure
- Pay for burial and funeral expenses
- Make necessary home repairs after a disaster
The amount you’re able to withdraw will be limited to the amount necessary to cover the expense.
How a 401(k) loan works
Given all the drawbacks of early withdrawals, you might consider borrowing from your 401(k) instead.
In general, you can borrow up to $50,000 or 50% of your vested account on a tax-free basis if you repay the loan within five years. That said, if you leave your job, you may be expected to pay off the loan in a short period of time. A 401(k) loan can be a better option than an early withdrawal for a couple of reasons:
- You won’t owe taxes or a penalty on the amount you borrow unless you violate the loan limits and repayment rules.
- If you repay the loan on time, you won’t miss out on years of growth like you would with a withdrawal.
- The interest you pay on a 401(k) loan can go back into your 401(k).
That said, some 401(k) loan plans don’t let you contribute to retirement while you have an outstanding balance. Additionally, the money you use to pay back the loan is already after-tax income. This money will be taxed again once you take it out after you’ve retired.
401(k) early withdrawals during a recession
A recession spells out bad times for all. Gross domestic product (GDP) falls and industrial production slows down. Most noticeably of all, unemployment rates rise. You may find yourself on the wrong side of that trend with dwindling savings. You do have a nice amount of money that you set aside for a future version of yourself.
It’s a tempting idea that many people follow through on. A study from the IRS conducted in 2013 found that in 2004, prior to the Great Recession, 13.3% of people with some retirement plan experienced a taxable retirement account distribution — essentially they did an early withdrawal. That percentage rose to 15.4% in 2010.
An early withdrawal should be a last resort. If you can afford not to withdraw early, do so. However, like many other issues within personal finance, recessions impact income levels differently. The same survey states that lower-income households have a higher propensity for an early withdrawal because they’re more deeply impacted by the economic shock.
The bottom line
You can access the money in your 401(k) before the traditional withdrawal age of 59 ½, but you should consider alternatives before committing to an early withdrawal. Keep in mind that your take-home will only be about 70% of the withdrawal amount after factoring your 20% tax and 10% penalty.
Also keep in mind the money you could’ve earned if you had kept that money invested, which you can calculate using one of the many future gains calculators available online.
If you see no alternative, take out only what you absolutely need right now, which will minimize how far back you’re setting your retirement.
To read the full article, click here.