Life has a way of backing you into a corner with circumstances beyond your control. Sometimes you might feel you have no other choice than to take a hit and use your 401(k) retirement plan for paying off medical bills, funding a bankruptcy or getting out of debt. Your job might even demand that you return to college and further your education to get ahead, at your own expense.
Although 44% of Americans tap into their 401(k)s early, according to a recent GOBankingRates survey, anyone considering a 401(k) early withdrawal should consider the consequences and alternatives first. Here’s what this 401(k) withdrawal guide will cover:
- What Is a 401(k) Withdrawal?
- What Age Can You Take Money Out of Your 401(k)?
- Is the Money in Your 401(k) All Yours?
- How Are 401(k) Withdrawals Taxed?
- What Is the Penalty for Early 401(k) Withdrawal?
- Long-Term Drawbacks of Withdrawing From Your 401(k) Early
- Tips for Withdrawing From Your 401(k) Effectively
- Alternatives to 401(k) Withdrawals
- Your 401(k) Withdrawal Plan Is Up to You
What Is a 401(k) Withdrawal?
A 401(k) withdrawal is when you take money from your 401(k) plan. Once you turn 59 1/2 years old, you will be fully eligible for the funds you’ve contributed to your 401(k). But withdrawing early will rack up penalties and taxes on your distribution, plus your 401(k) will have less money left in it for your retirement.
Typically, there are periodic and nonperiodic withdrawals:
- Periodic withdrawals are installment payments.
- Nonperiodic withdrawals are distributed as one lump sum.
Most large 401(k) plans allow eligible retired individuals to withdraw money in regularly scheduled installments, usually monthly or quarterly. About two-thirds of large plans let retirees take partial withdrawals whenever they want.
Either way, withdrawing money from your 401(k) has benefits as well as downsides. The best advice is to research how each option impacts your finances and your retirement.
What Age Can You Take Money Out Your 401(k)?
There are rules regarding when you can take money out of your 401(k). Withdraw too soon and incur penalties. Withdraw too late and also incur penalties. So, how does the 401(k) withdrawal age affect when you can cash out some of your funds without facing penalties?
You’re allowed to withdraw money from your 401(k) once you turn 59 1/2. An early withdrawal — one you take before you turn 59 1/2 unless you qualify for an exception — might result in a 10% 401(k) withdrawal penalty in addition to the income tax you’ll pay on the amount you took out.
No matter your age, you can tap into your 401(k) to take a hardship withdrawal, or you can take out a loan, both of which are discussed later in this guide.
Also, be aware that you cannot keep money in your 401(k) retirement plan indefinitely. You have to start taking withdrawals after you reach age 70 1/2 unless you’re still working for the employer offering the 401(k). But you can continue contributing while you work for that company, too.
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What Is the Required Minimum Distribution?
The minimum amount you must withdraw from your retirement account each year is called the required minimum distribution.
The following rules apply for the required minimum distribution:
- You can take more money out of your account than the minimum required amount.
- The money you take out will be taxable income, except for any part that was taxed previously or can be collected tax-free.
Keep in mind that if you don’t withdraw any money out of your retirement account after you reach the age of 70 1/2, or your withdrawals are not large enough, you might have to pay a 50% excise tax on any amount not withdrawn as required by your plan.
Anyone who owns 5% or more of the business where they have their retirement plan must start taking money out by April 1 of the year after they turn age 70 1/2. So, if you turn 70 1/2 in 2022, you must start taking money out of your plan by April 1, 2023, even if you still work there.
When Can You Withdraw Funds From Your 401(k) Penalty-Free?
Certain circumstances will allow you to withdraw money from your retirement account penalty-free.
For example, employees age 55 or older can withdraw 401(k) funds without incurring a penalty if they terminate their employment with the company where they have their 401(k). In the event that you still have a retirement plan with a previous employer but you left that employer before the age of 55, you will still have to pay the 10% penalty if you take money out of that plan.
Certain qualifying situations allow for a penalty-free 401(k) hardship withdrawal if your plan and your employer allow it. Here are the circumstances the IRS typically considers to be hardships:
- Extensive medical debt
- First home purchase
- College tuition
The amount you can withdraw is limited to the amount needed to satisfy the financial need created by the hardship. You don’t have to repay a hardship withdrawal, but the money you withdraw is taxed.
Is the Money in Your 401(k) All Yours?
Is all of the money in your 401(k) yours? Yes and no — here’s how 401(k) vesting works. Say the company you work at offers a 401(k) plan to employees and matches employees’ contributions to their accounts. Over time, the contribution you make to your plan, matched with your employer’s contribution, adds up to a tidy little sum for your retirement. But when your employer participates in a vesting schedule — a schedule by which your employer’s contributions to your account are yours to keep — you can’t claim all your 401(k) funds until you’ve been employed for a set period of time, which is laid out in your plan.
Vesting is set up as an incentive for employees to remain with a company for a certain amount of time. Although the money you contribute is 100% yours, your employer’s matching funds vest over time — usually 25% or 33% per year, or all at once after a certain number of years.
Once you’re fully vested, you can take your entire 401(k) balance, including your company match, when you leave your job. Partially vested employees may keep the vested portion of their employer’s matching contributions.
How Are 401(k) Withdrawals Taxed?
Contributions to your retirement plan are paid with pretax dollars. Because taxes were deferred on your contributions, taxes will become due on your 401(k) funds once you start withdrawing money from your plan.
These withdrawals are taxed as ordinary income at the tax rate for your tax bracket in the year you start taking your funds, and your 401(k) retirement plan withdrawal is subject to a mandatory 20% withholding tax. The withholding tax doesn’t apply to rollovers.
What Is the Penalty for an Early 401(k) Withdrawal?
Taking money out of your 401(k) retirement plan early might sound like a good idea compared to borrowing money or putting a large expense on a credit card. But if you cash out your 401(k) or access your funds before you reach the age of 59 1/2, you will likely face a 10% early withdrawal penalty on the sum you took out. What that means is if you take out $5,000 at age 48, you’ll lose $500 as a penalty, and you’ll pay personal income tax on the whole $5,000.
Long-Term Drawbacks of Withdrawing From Your 401(k) Early
Because 401(k)s are set up as retirement plans, cashing out early can set you back considerably. You will have less money now because of the penalty and tax, and you’ll lose even more over the long term because your money will not have the opportunity to grow or be matched by your employer in the years until you retire.
Say, for example, you withdraw $5,000 from your 401(k). Even without an employer match, at an average annualized return of 7%, in 10 years you would have had a nest egg of $9,836, plus your tax savings on the initial, tax-deferred investment. In addition to missing out on that extra $4,836, you’ll be hit with a 10% — $500 — tax penalty for early withdrawal, and you’ll owe income tax on the $5,000.
Tips for Withdrawing From Your 401(k) Effectively
When you are ready to withdraw funds from your 401(k), you still want to be strategic. Follow these pointers:
- After you’ve left your job, wait until after the age of 59 1/2 to withdraw money from your 401(k).
- If you’re withdrawing early, make sure that your situation qualifies for a penalty-free exception.
- Don’t leave your job until you turn 55 so you can withdraw money without penalty.
- If you want to withdraw early, find out if you qualify for penalty-free distributions under rule 72(t) from the IRS, which requires you to take equal periodic payments for at least five years, until you’re at least 59 1/2.
- Consider reinvesting 401(k) withdrawals in an annuity.
Keep Reading: Ways To Maximize Your Retirement Benefits
Whether you need cash or your current 401(k) just isn’t meeting your financial goals, you have options that will help you avoid penalties and taxes. Here are alternatives to a 401(k) withdrawal, along with pros and cons.
A 401(k) Loan
Taking a loan on your retirement plan isn’t completely without benefits, but not all plans allow you to borrow against your funds. Among those that do, there is no withdrawal penalty or income tax due on a 401(k) loan as long as you repay it within five years or before you separate from your employer. You can borrow up to $50,000 or half the vested balance in your account.
You might be able to roll over to a new 401(k) in some circumstances, but the new plan could be more limited or not as good as your current 401(k) and you might be hit with fees.
Convert To a Roth IRA
Money in a 401(k) plan isn’t taxed when you contribute to it, but the money is taxed when you start taking out funds. When you have a Roth IRA, you pay taxes on the money you contribute, but you withdraw tax-free in retirement as long as you meet the qualifications.
Whereas a 401(k) is set up through an employer, you’ll have to open your own Roth IRA account through a bank or investment firm.
Instead of using a 401(k) withdrawal to cover a personal expense, you could use a personal loan. A loan pays out a lump sum upfront, but there is a finite date when payments are due, and you pay interest on your balance. But you can use your loan for almost anything, and you can access your money anytime instead of waiting until you retire or paying penalties on an early withdrawal.
Having a 401(k) gives you a more solid financial footing compared to the 35% of adults in the U.S. who have only several hundred dollars in their savings accounts and the 34% who have zero savings, according to a GOBankingRates survey. Withdrawing money from your retirement savings before retirement might solve a problem now, but it can potentially create a much larger problem in the future. Unless you need to withdraw funds from your 401(k) because of hardship, the best possible scenario for your future is the peace of mind that comes from knowing you have money set aside for your retirement.
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