7 Times It’s OK to Dip Into Your Retirement Fund Early

If you're taking an early 401k withdrawal, make sure you're aware of the full cost.

Taking an early withdrawal from your 401k is not only costly in the short term, it can also jeopardize your long-term retirement goals. If you withdraw retirement accounts before the penalty-free 401k withdrawal age of 59.5, you’ll be forfeiting the benefits of tax-deferred earnings and compounding interest, which diminishes the savings power of 401k accounts. These plans are specifically designed for long-term investing, making the years work in the contributor’s favor.

Because of the severe financial penalties, withdrawing money early from retirement accounts should only be done in an extreme emergency, ideally after any emergency funds and investments have been depleted. If you are in a financial pinch and considering taking money out of your 401k or any other retirement savings account, here are seven times it’s OK to dip into your retirement fund early.

retirement early withdrawal

7 Situations When You Can Withdraw Money From Your Retirement Savings

Certain qualifying situations allow for a penalty-free hardship withdrawal, but employers are not required to provide these kinds of 401k withdrawal rules. Some people have to take the hit of the penalty for withdrawing early from retirement savings just to stay financially afloat.

Emily LaRusch, founder of Back Office Betties, which offers full-time virtual receptionists, has experienced this firsthand. “In 2010, I was days away from having my second baby when I was laid off,” LaRusch said. “I made the decision to close my 401k and accept the penalties in order to support my family while I stayed at home for the first year with my son.”

In extreme situations like LaRusch’s, after carefully thinking it through and running the numbers with a 401k withdrawal calculator, you might find it’s still in your best interest to make a 401k withdrawal or other type of early distribution — even if there are penalties. If you find yourself in one of the following scenarios, withdrawing money early from your retirement savings might be financially prudent.

Read: 12 Secret Moves to Double Your 401k

IRA withdrawal disability

1. You Become Totally and Permanently Disabled

You can take penalty-free distributions from qualified plans due to a total or permanent disability. Minor or partial disabilities don’t qualify.

According to the IRS, you are considered disabled if:

  • You can provide proof that you cannot do any substantial gainful activity because of your physical or mental condition.
  • A physician determines that your condition can be expected to result in death or to be of long, continued and indefinite duration.

Some experts recommend first applying for state disability insurance to make it easier to prove your status to the retirement plan administrator. To take a 401k hardship withdrawal, you must fill out IRS Form 5329 to get out of paying the penalty and ensure you are adhering to IRS 401k loan rules.

IRA withdrawal medical debt

2. You’re Drowning in Medical Debt

You can withdraw from your retirement accounts to cover unreimbursed, out-of-pocket medical expenses that exceed 10 percent of your adjusted gross income. These expenses must be paid in the same year you take the distribution and the distribution is not subject to penalty of tax if withdrawn from an IRA.

The difference between these expenses and 10 percent of your AGI is eligible for this exception. For example, if your AGI is $60,000 and your unreimbursed medical expenses are $9,000, the maximum amount that you can distribute without penalty is calculated as 9,000 – (60,000 x 0.10) = $3,000.

IRA withdrawal divorce

3. You’re Getting Divorced

If you get divorced, you might be required by court to divide the funds with your former spouse or a dependent. These distributions are usually ordered under a property settlement under a qualifying domestic relations order and are exempt from an IRA or 401k withdrawal penalty.

401k withdrawal business

4. You’re Starting a Business

Many personal finance experts will probably advise otherwise, but you might be able to use your 401k and IRA funds to finance a small business or startup. This process isn’t simple, and there are significant legal steps you will need to take, including rolling the money over into a corporate retirement account that allows you to invest in the business. It’s best to consult a financial planner or third-party retirement-plan administrator for help with this.

For some entrepreneurs, this move has been well worth the effort and extra risk. Jason Fisher is the owner and founder of Waterway Financial Group, which provides holistic financial planning. Fisher drained his 401k to start his small business.

“I tapped out my entire 401k to begin a small business,” Fisher said. “While it wasn’t a ton of money, it was crucial for my business to have as much capital up front as possible, and the hit I took in penalties and taxes was well worth it. The way I look at it, I was able to compound my money in a business much faster than anticipated in the market, and I was correct. Obviously, the risk was greater, too.”

early withdrawal buy a house

5. You’re Purchasing Your First Home

You can take up to $10,000 from your IRA free of penalty to purchase your first home. The money can be used for reconstructing, acquiring or building a residence for the account holder, spouse, children, grandchildren or ancestors. You are considered a first-time homebuyer if you have not owned a home for the last two years.

The $10,000 limit is per person, so if two people are purchasing the home, you can take out twice as much. Ian Aronovich, cofounder of GYFU, which provides indoor location context marketing and analysis, said that about four years ago, he and his partner pulled roughly $20,000 from their retirement funds.

“[We used this] not as a loan but as a distribution, to help with the purchase of our first home,” Aronovich said. “Since a $10,000-per-person withdrawal is allowed without an early withdrawal penalty when used to buy your first house, it made perfect sense.”

early withdrawal college

6. You Need to Pay for Higher Education

This only qualifies for students that are at least 18 years old, and the funds must be used for tuition payments. Financial advisors usually recommend account holders invest more heavily in retirement accounts than 529s to maximize eligibility for financial aid, because colleges don’t consider retirement accounts when determining how much aid you qualify for.

Also, 529 contributions don’t yield a federal tax deduction, so this tactic might also reduce your federal tax bill, although there are state income tax deductions associated with 529 contributions. Depending on whether you are withdrawing from a 401k or IRA, different rules regarding loans and AGI apply, so this must be carefully thought out and timed. Consider consulting a professional for help.

early withdrawal foreclosure

7. You Are Facing Foreclosure

In previous years, homeowners would use home equity lines of credit as a resource to avoid foreclosures. The post-recession economy has taken that option off the table for many people and their next best option might be using retirement savings to bridge the gap.

Many retirement savings plans allow you to use the funds to prevent foreclosure on your primary residence. You can either borrow from your 401k or IRA and pay back the money within a specific time frame or just withdraw the money. You might pay penalties and tax, so consult your plan administrator before you make the decision.

“The only time I would take the penalty would be in the case where my family might end up out on the street,” said Paul Moyer of SavingFreak, a savings-dedicated website. “A house foreclosure is one of those times I might incur the penalty on my accounts. Before doing that I would definitely meet with someone who was not emotional about the subject and have them help me do the math and see if the mortgage is salvageable after we were to get through the current hard times.”

early withdrawal retirement

Bottom Line on Withdrawing Retirement Funds Early

Withdrawing money early from your retirement accounts — that is, borrowing against your 401k or IRA — carries heavy financial consequences, but sometimes the benefit outweighs the cost of taking out a 401k loan. Take this opportunity to assess your financial situation and ask yourself if the problems you’re having are only temporary — or if they’re the sign of a much larger issue. Make a new financial plan that will protect you from facing this kind of difficult and costly decision again in the future.

Knowing when your situation is not a good excuse for borrowing from your 401k or IRA is important, too. Don’t use your retirement fund to pay off credit card debt, or pay for expenses like a wedding or a car — retirement funds are not savings for a rainy day.

“Because of the tax advantages of retirement funds and the penalties involved in early withdrawals, I would consistently shy away from ever tapping those accounts if I could ever avoid it,” said Moyer.

Keep Reading: 15 Mistakes Even Smart People Make in Retirement