10 Lessons on 401k Withdrawal Rules and Options

Review 401k withdrawal rules to avoid losing any of your savings.

Saving money in a 401k through your employer is a great perk — but unfortunately, one out of three private-sector workers over the age of 22 don’t have access to a 401k, according to The Pew Charitable Trusts. If you’re one of the lucky employees who can participate in an employer-sponsored plan, you need to know 401k basics including when you can make withdrawals.

Review these 10 lessons about how to make savvy withdrawals from your 401k. Being knowledgeable about 401k withdrawal rules will help you maximize your employer-sponsored nest egg.

1. You Can’t Access Your 401k Money at Will

Unlike an IRA withdrawal, you can’t make a 401k withdrawal whenever you want. Instead, you must meet the requirements to qualify for a distribution. Eligible situations include leaving your job, suffering a permanent disability or turning 59 and a half. Your plan might allow for a 401k hardship withdrawal or 401k loan, but those allowances are at the discretion of your employer.

2. Employers Set Vesting Schedules

If your employer makes contributions to your 401k plan on your behalf, it can determine when that money belongs to you 100 percent. Companies can meet one of two vesting schedules:

  • You must be 100 percent vested by the end of your third year of employment.
  • You must be at least 20 percent vested after the end of your second year and gain an additional 20 percent each year until you are fully vested after the sixth year.

If you leave before you are fully vested, your unvested employer contributions won’t be yours to keep. But any contribution you make is always fully vested.

Learn: 10 Big 401k Questions to Ask Your Employer

3. Learn the Hardship Distribution Rules

Your 401k plan likely includes rules for making a hardship withdrawal and each plan specifies what qualifies as one. For example, a plan might allow hardship distributions for medical and funeral expenses but not for education expenses. Keep in mind that because an expense qualifies for a hardship distribution it doesn’t mean you’ll avoid a 10 percent early withdrawal penalty.

Click to see the best 401k companies for your nest egg.

4. Early Withdrawals Come With Penalties

If you take a distribution — including a hardship withdrawal — prior to the 401k distribution age of 59 and a half, you’ll owe an extra 10 percent penalty on top of the taxes you’ll pay unless an exception applies. For example, if you take out $10,000 as a hardship distribution to pay for a funeral, you might owe income taxes on the $10,000 plus an extra $1,000 penalty depending on your 401k plan. Be very careful about withdrawals, particularly if you want to retire early.

5. Penalty Exceptions Exist

Once you hit age 59 and a half you can take a penalty-free 401k withdrawal for any reason — you can also take one if you suffer a permanent disability or leave your job after you turn 55, or 50 if you are a qualified public safety employee. You can withdraw penalty-free if you have medical expenses in excess of 10 percent of your adjusted gross income, which goes down to 7.5 percent if you’re over 65. And last, if you inherited your 401k, you can withdraw without paying a penalty.

See the best investment brokers for your money.

6. A 401k Loan Might Work for You

If you don’t want to pay an early withdrawal penalty, consider a 401k loan — assuming your plan permits them. You can borrow as much as half of your vested account balance, or $50,000, whichever is smaller. The one exception being if 50 percent of your vested balance is under $10,000, in which case you can borrow up to $10,000.

You can repay the loan with interest over five years — or longer if you’re borrowing to buy a primary residence. You’ll get the interest added back to your 401k plan balance, but you’ll miss out on any market gains — or losses — while the money is on loan to you.

Read: Borrowing From Your 401k — What You Need to Know

7. 401k Loans Have Tax Consequences

As long as you repay the 401k loan on time, you won’t owe any taxes or penalties. However, if you default on your repayments, the IRS treats the outstanding loan balance as a permanent distribution, which means you’ll owe taxes and — unless you’re over age 59 and a half — an extra, 10 percent tax penalty. You might want to consider other options, such as a personal loan, prior to tapping your 401k.

Read This: The 7 Must-Have Things All Brokers Have in Common

8. You’ll Be Taxed on Distributions

For traditional 401k plans, you’re required to include the amounts you withdraw in your taxable income because it wasn’t taxed when you contributed it. For Roth 401k plans, your qualified distributions come out entirely tax-free. To take a qualified distribution from a Roth 401k, you must have the account open for five years and be either 59 and a half years old or permanently disabled.

Find Out: 5 Retirees Reveal What They Wish They’d Done With Their Money

9. You Have Rollover Options

If you leave your job you don’t have to empty your 401k and pay the taxes and penalties that would come with a distribution. Instead, you can roll over your old 401k into a 401k at your new job or open a traditional IRA on your own. You can also convert it to a Roth IRA; you’ll owe taxes on the amount you convert but won’t have to pay any penalties.

Do you want to save even more for retirement? Consider investing in the Best Roth IRAs and the Best Traditional IRAs.

10. Your 401k Requires Withdrawals

You can’t leave the money in your 401k plan forever. Once you turn 70 and a half, you must start taking a portion of the money out each year. If you don’t, the IRS imposes a 50 percent penalty on the amount you fail to withdraw. As long as you don’t own 5 percent or more of the company you’re investing through, you can delay taking mandatory 401k withdrawals until you retire.

The tax advantages of a 401k plan and employer contributions make participating in one a no-brainer. Although there are substantial pitfalls that can take a bite out of your 401k savings, knowing the rules can help you avoid penalties, take advantage of tax breaks and save wisely for your retirement.

Keep Reading: The 15 Best Brokers for Your Money

Joel Anderson contributed to the reporting for this article.

More on Retirement Investments