The Pros and Cons of Withdrawing on Your 401(k) Early
People love 401(k) plans because they’re simple, contributions are automatic and, in many cases, they offer free money in the form of matching employer funds. Unlike Roth IRAs and annuities, however, 401(k) plans are frustratingly inflexible. They come with strict rules and tough penalties regarding early withdrawals. Here’s what you need to know about pulling funds from your 401(k) before the IRS says it’s time.
In Most Cases, You’ll Take a Big Hit for Tapping Your 401(k) Early
When you reach the age of 59 1/2, you can start withdrawing from your 401(k) worry-free, but until you reach that magic milestone, the assets inside are off-limits. If you do pull from your funds early, the IRS will withhold 20% for taxes. If you withdraw $5,000, for example, you’ll receive only $4,000. Some of this might be refunded come tax time, but that will depend on your personal tax situation.
On top of that, you’ll be hit with a 10% early withdrawal penalty, courtesy of the IRS.
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Forget Your 401(k) Exists Unless You’re Really Desperate
401(k) plans were designed specifically to incentivize people to save for life beyond their earning years. To discourage people from squandering their nest eggs, the IRS makes it difficult and expensive to pull their money out early.
“It’s important to remember that a 401k plan is a retirement savings vehicle,” said Matthew Compton, director of retirement services at Brio Benefits, a full-service employee benefits consulting firm based in New York City. “The government and the IRS provide tax benefits as a way to encourage individuals to save for retirement. That being said, unexpected events can inevitably occur during a person’s life that make it necessary to tap into their retirement nest egg.”
But those unexpected events should qualify as an emergency or something close to it if you’re even considering raiding your retirement fund.
“In general, you want to use withdrawing from your 401k as a last resort,” said chartered financial analyst Greg Wilson, who recently retired to run ChaChingQueen and ClothDiaperBasics with his wife Erin. “It’s like stealing from your future self. But there are instances where you can avoid the 10% early withdrawal tax.”
What Are the Exceptions to the Penalty Rules?
Even an emotionless bureaucracy like the IRS recognizes that extenuating circumstances can force even the most prudent savers into the tough decision of tapping into their 401(k) plans early.
“A 401k participant typically needs to reach a qualifying event in order to access their 401k balance,” Compton said.
Qualifying events, however, are few and far between — and even then, there’s no guarantee that you’ll get to keep all your money.
“Anyone withdrawing from their 401k before age 59 1/2 will still have to pay taxes on the distribution as ordinary income,” said Laura Vogel, a FINRA member, licensed registered representative and financial services professional with New York Life. “That being said, the extra 10% penalty that usually comes along with early withdrawals can be waived for things like higher education costs, a first-time home purchase, and some medical expenses.”
The direst circumstances can leave people with few other good options.
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“You may want to consider an early withdrawal if you become permanently disabled,” Wilson said. “Disability is a situation that is exempt from IRS’s early withdrawal penalty.”
But in other cases, it’s up to the individual to decide if the circumstances truly justify an early withdrawal.
For example, Vogel thinks it makes sense to tap your funds early for a down payment on a home, but Wilson doesn’t think that’s an extraordinary enough circumstance to qualify.
“If you want the money to buy a home, maybe it isn’t the right time to buy a home,” Wilson said.
Among the other exceptions allowed by the IRS are 401(k) rollovers, satisfying an IRS levy and military reservists called to active duty.
Consider a 401(k) Loan or Hardship Withdrawal Instead
The good news is, early withdrawals aren’t the only option for people who truly need to access their money.
“Most 401k plans allow a participant to tap into their 401k balance without reaching a qualifying event via a loan or hardship withdrawal,” Compton said. “If loans are available, that is typically the better option as it allows the participant to borrow money from themselves, and the interest on the loan is applied back to their own balance rather than paid to an outside financial institution. Typically, 50% of a participant’s total balance can be taken via a loan, with a maximum loan amount of $50,000.”
If a loan is not available, or if the account holder has an immediate financial need, then the participant can request a hardship distribution.
“This type of distribution needs to be made by the participant to their employer and all facts and circumstances need to be presented before the distribution can be approved,” Compton said. “It’s important to note that with a loan there are no taxes and/or penalties, whereas with a hardship distribution there will be taxes as well as a 10% penalty if a participant is not over 55 years of age. Beyond these options, it’s almost always in a participant’s best interest to not take distributions from their account until they have reached the age of 59 1/2.”
The entire discussion is proof that retirement planning isn’t a one-size-fits-all proposition, and that accounts with greater flexibility are often a better choice for a lot of savers.
“The best option is having your own privately owned plan that allows for withdrawals like a Roth IRA or an annuity,” Vogel said. “There still may be limits to how much you can take, but you usually aren’t subject to the taxes and penalties.”
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