Early 401(k) Withdrawals: How To Cash Out and Avoid Penalties

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An employer-sponsored 401(k) plan encourages you to save for retirement by allowing pretax contributions from your paycheck and tax-deferred growth on your investments. The catch is that you can’t withdraw the money before you turn 59½ years old unless you are experiencing a serious financial hardship or are willing to incur a 10% penalty — and both options have additional consequences you need to consider before making an early withdrawal.

If you were hoping to get a penalty-free early 401(k) withdrawal as part of the federal government’s COVID-19 relief efforts, you’re out of luck there. A program implemented during the early days of the pandemic allowed people younger than 59½ to take up to $100,000 from their retirement accounts without the usual 10% penalty. But that program was discontinued in 2021 and is no longer available.

If you’ve explored all other options and still feel like you need to access your 401(k) funds and cash out, there are ways to do so without a penalty. Keep reading to learn more about 401(k) withdrawal rules.

How To Make an Early Withdrawal From a 401(k)

If you are considering making an early withdrawal from your 401(k), your first step is to find out if your plan even allows one. Not all plans do. Contact your plan administrator to find out what kind of withdrawals your plan allows. This might include financial hardship withdrawals, but not all plans allow those, either.

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If your plan does allow early withdrawals, here are some steps to follow:

1. Determine Whether You Qualify for a Hardship Withdrawal

The IRS defines a hardship as an “immediate and heavy financial need.” This is the type of withdrawal you should take if you qualify — you’ll still have to pay income tax on the money, but you won’t be charged the 10% early withdrawal penalty in many cases. Examples of financial hardship include the following:

Keep in mind that the IRS limits hardship withdrawals to the amount that’s necessary to satisfy the need.

2. Decide How Much To Withdraw

All early withdrawals from your 401(k) are taxed as ordinary income. That’s the case even if the withdrawal was covered by an exception. The IRS typically withholds 20% of an early withdrawal to cover taxes, and that is in addition to the 10% penalty for a non-hardship withdrawal. You’ll need to account for these amounts when you calculate how much to withdraw. For example, if you withdrew $10,000 from your 401(k), you might only receive $7,000 after the 20% IRS tax withholding and a 10% penalty.

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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.

3. Request a Withdrawal

If you still work for the employer that sponsors your plan, ask the plan administrator for a withdrawal form. Your company might call this a hardship or distribution form. On the form, you’ll need to specify the type of withdrawal you’re requesting, the reason for the hardship, and how much you want to withdraw. You can also submit documents that support your hardship request.

If you have left the employer that sponsors your plan, you can request a withdrawal from the investment company that holds your account. The easiest way is to go to the firm’s website and register your account if you haven’t already. Once you have online access to your account, navigate to withdrawal options and follow the prompts to request your withdrawal. You’ll indicate that you’re requesting a hardship withdrawal, or if you want to cash out entirely, a termination.

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The investment firm might charge you a distribution fee, so you’ll have to account for this as well.

Good To Know

The 20% mandatory withholding is essentially an upfront income tax payment on the amount you withdrew. If you wind up owing more or less than the amount withheld, you’ll square it away when you file your tax return.

How To Avoid the Early Withdrawal Penalty

The IRS does allow certain exceptions to the 59½ minimum age requirement. These typically involve penalty-free withdrawals under special circumstances related to death, disability, medical expenses, child support, spousal support and military active duty. Visit the IRS’s FAQ page on Hardship Distributions to see if you qualify.

Even if you don’t qualify, other options exist that might let you make penalty-free withdrawals if you’re closing in on retirement age. For example, if you are between the ages of 55 and 59½ and you lose your job, the IRS will let you withdraw from your 401(k) plan without penalty under the Rule of 55.

The 55 rule applies to these scenarios:

  • You leave your job in the calendar year that you will turn 55 or later, or age 50 or later if you are a public safety worker. This applies even if you were laid off, terminate or quit.
  • The funds are being distributed only from a 401(k) account offered by your last employer. If you withdraw from accounts with other past employers, you’ll get charged a 10% early withdrawal penalty.

Another penalty-free option is the Substantially Equal Periodic Payment exemption, which lets you “take substantially equal payments from your 401(k) based on life expectancy,” according to Bryan Stiger, CFP, who works with Betterment as a financial advisor in 401(k) products, in an article from Forbes. This applies when you withdraw money from a qualified retirement account under Rule 72(t), which is a part of the Internal Revenue Code that outlines the process of making early withdrawals from 401(k)s and other qualified retirement accounts. Under this rule, the funds are distributed to you as regular SEPP payments made over five years or until you turn 59½.

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.

Once you do the math, it’s easy to see how early withdrawals can adversely affect your retirement goals.

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.

Alternatives to a 401(k) Early Withdrawal

If you still need money from your 401(k) account but can’t use an approved exemption or the rule of 55 or SEPP options, there are a couple of ways to access the money to help you avoid a penalty. Here’s a quick look.

401(k) Loans

This is a good option as long as you are confident you’ll be able to pay the loan back. Some 401(k) plans let you borrow up to 50% of your vested account balance — with a maximum amount of $50,000 – with terms that usually involve repaying the loan within 12 months. In certain cases, you might be able to get a longer repayment period, like if you are borrowing for a home down payment.

401(k) loans work like standard loans in that you’ll be responsible for paying back the borrowed funds with interest. Just keep in mind that if you default on your repayment, it will be considered a distribution, meaning you could get hit with the 10% penalty for early withdrawals. 

Another thing to consider: If you leave your company, you’ll only have a very short time to repay the loan, typically less than a year but no later than the Tax Day of the subsequent year. If you don’t meet the deadline, your loan will be treated as an early withdrawal and be subject to the same taxes and penalties. 

401(k) Rollover

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. 

Hardship Withdrawals

As mentioned above, some plans let you take a penalty-free hardship withdrawal to meet an “immediate and heavy” financial need. You’ll have to check with your plan administrator or HR manager to see if your plan offers this option — and if they do, whether early withdrawal penalties are waived. Even if your plan permits hardship withdrawals, you might still be on the hook for the 10% early withdrawal penalty unless you fall within one of the exceptions outlined earlier.

If you do take a hardship withdrawal, you won’t be able to make elective contributions to your 401(k) plan for at least six months, which could set back your retirement savings goals.

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.

Personal Loan

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. 

Final Take

If you can avoid it, you’re always better off not taking an early 401(k) withdrawal, especially if it means paying the 10% penalty. Use this option only as a last resort. It’s also advisable not to take a hardship withdrawal or get a 401(k) loan unless there are no other options. Remember that your 401(k) is intended as retirement savings – which is one reason you can get penalized for tapping into it early – and you might one day depend on that money to pay your bills.

An early withdrawal affects your retirement savings in two ways. First, you’ll reduce your account balance, with could leave you behind in your savings goals. In addition, and perhaps more costly, are the opportunity costs — lost investment returns on the amount you withdraw. The more time you have before you retire, the more you stand to lose in lost growth opportunities.

If you feel you have no other choice, try to take advantage of a penalty-free option such as the Rule of 55 or the SEPP exemption. Before making a move, speak with a tax advisor to find the best solution.

Vance Cariaga, Kathryn Pomroy, Daria Uhlig and John Csiszar contributed to the reporting for this article.

401(k) Withdrawal FAQs

Here are the answers to some of the most frequently asked questions about 401(k) withdrawals.
  • 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.
  • 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.
  • 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.

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About the Author

Daria Uhlig is a personal finance, real estate and travel writer and editor with over 25 years of editorial experience. Her work has been featured on The Motley Fool, MSN, AOL, Yahoo! Finance, CNBC and USA Today. Daria studied journalism at the County College of Morris and earned a degree in communications at Centenary University, both in New Jersey.
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