Taking an early withdrawal from your 401(k) is not only costly in the short term, but it can also jeopardize your long-term retirement goals. If you withdraw retirement accounts before the penalty-free 401(k) withdrawal age of 59 1/2, you’ll be forfeiting the benefits of tax-deferred earnings and compounding interest, which diminishes the savings power of 401(k) accounts. These plans are specifically designed for long-term investing, making the years work in the contributor’s favor.
Of course, life has a way of messing up even the best-intentioned plans, and the coronavirus pandemic is proving that point yet again. Many Americans either have already tapped their 401(k) plans or have considered the option in the midst of massive job layoffs and unemployment.
Because of the severe financial penalties, however, withdrawing money early from retirement accounts should only be done in an extreme emergency, and only after any emergency funds and investment have been depleted. Whether or not the coronavirus pandemic qualifies as an “extreme emergency” for you depends on your unique financial situation.
Last updated: April 21, 2021
Coronavirus Has Completely Disrupted Your Finances
If the effects of the coronavirus pandemic have decimated your finances, you’re not alone. According to one study, as of September 2020, a whopping 27% of Americans were considering tapping their 401(k) plans. That’s an extraordinary number for an account that is not only designed for retirement but that also carries significant financial penalties for early withdrawal.
If your emergency funds are gone and you have no income, however, you may have to consider your 401(k) plan as an option of last resort. Although the penalties are severe, if that money can keep you afloat until you start pulling down a paycheck again, it may be necessary.
Unfortunately, the provision put in place to waive early 401(k) withdrawals due to COVID-19 expired at the end of 2020. If you do choose to withdraw funds, you’ll be charged the 10% penalty tax as well as your income tax rate on the amount you withdraw.
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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.
In these scenarios, you might have an immediate need for funds that your 401(k) can provide. However, you should also consult with a financial advisor to try to devise a long-term financial plan, as draining your account immediately will leave you with nothing for your lifelong needs.
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Some experts recommend first applying for state disability insurance to make it easier to prove your status to the retirement plan administrator. You also might be able to get enough in state, federal or private disability payments to minimize the hit to your 401(k). To take a 401(k) hardship withdrawal, you must fill out IRS Form 5329 to get out of paying the penalty and ensure you are adhering to IRS 401(k) loan rules.
You’re Drowning In Medical Debt
You can withdraw from your retirement accounts to cover unreimbursed, out-of-pocket medical expenses. However, the bar is high. You can only take penalty-free withdrawals for unreimbursed medical expenses that exceed 10% of your adjusted gross income. If you only have a few thousand dollars in unreimbursed medical expenses, for example, you’re unlikely to qualify for a penalty-free withdrawal. These expenses must be paid in the same year you take the distribution.
You’ll need to make a calculation to see how much you can withdraw penalty-free from your 401(k) for unreimbursed medical expenses. Only your expenses that are more than 10% of your AGI are 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 $3,000, the difference between $9,000 and 10% of your AGI ($6,000).
You’re Getting Divorced
Divorce is not just emotionally traumatic, it might be a financial drain as well. If you get divorced, you might be required by court to divide the funds with your former spouse or a dependent. In this case, you won’t have a choice. By court order, you’ll have to dip into your retirement funds, making it an “acceptable” time to draw from your 401(k).
Distributions ordered under a property settlement are known as a qualifying domestic relations order. If you’re the account owner, the good news is that your distributions are exempt from an IRA or 401(k) withdrawal penalty. Thus, you can avoid any taxes or penalties on the amount you have to distribute under the order. The recipient will have to consult with their tax expert to determine their own tax ramifications.
You’re Starting a Business
Many personal finance experts will probably advise otherwise, but you might be able to use your 401(k) and IRA funds to finance a small business or startup. The process is known as a “rollover for business startup,” or ROBS. Many providers have sprung up to facilitate this transaction, which essentially involves rolling over your 401(k) to your new business.
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. The IRS itself says that while a ROBS arrangement is not strictly an “abusive tax avoidance transaction,” they are still questionable transactions. It’s best to consult a financial planner or third-party retirement-plan administrator for help with this.
You’re Purchasing Your First Home
Generally, you shouldn’t be raiding your retirement funds to pay for your home. Ideally, you’ll save up until you can put a substantial down payment of at least 20% toward your house. However, if it’s your first home, you may just be starting out financially and need a little extra boost. Recognizing this, the IRS will allow you to take up to $10,000 from your IRA free of penalty to purchase your first home.
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The good news about the first-time homebuyer exemption regarding 401(k) penalties is that the rule is extremely flexible. Yes, the money can only be used for reconstructing, acquiring or building a residence for the account holder, spouse, children, grandchildren or ancestors. However, from the perspective of the IRS, you are considered a first-time homebuyer if you have not owned a home for the last two years. This means you can take advantage of this exemption multiple times throughout your life if you so desire.
You Need To Pay For Higher Education
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.
Retirement plan withdrawals for qualified higher education expenses are one of the few differences where it matters if you’re withdrawing from your 401(k) or your IRA. An education withdrawal from a 401(k) is still subject to the 10% early withdrawal penalty, but this can be avoided with an IRA withdrawal for the same purpose. In this case, you’d generally be better off taking educational money from your IRA than your 401(k). As this area of tax law can get tricky, you’ll definitely want to consult with a tax expert for these types of decisions.
You Are Facing Foreclosure
Foreclosure definitely qualifies as a financial emergency. Although ideally, you’ll never want to tap your retirement funds, if the choices are to keep your retirement intact but lose your house, many homeowners would choose the latter. The IRS understands this, and therefore there is permission to withdraw from a 401(k) to stave off foreclosure.
The IRS allows you to withdraw funds from your 401(k) plan to prevent foreclosure on your primary residence. However, it’s important to note that you might pay penalties and tax, so consult your plan administrator before you make the decision. Even in this dire situation, consider your 401(k) plan as an option of last resort. If you’re able to renegotiate your mortgage or work out some sort of payment plan with your lender, it’s usually preferable to withdrawing from your retirement account, even if the cost is expensive. At emotional times like this, it can be very helpful to get someone from the outside to help you look at your situation, such as a tax or financial planner or even an informed, trusted friend.
Alternatives to Dipping Into Your 401(k) Early
The above situations can all be considered valid reasons for taking money out of your 401(k) early. However, just because there are situations in which you’re allowed to withdraw from your 401(k) prematurely without penalty doesn’t mean that you should. Even if you find yourself in one of the above situations, you may have viable alternatives to siphoning funds from your 401(k). Read on to learn about some of the most popular.
Take Out a 401(k) Loan
A 401(k) loan may be one of the best ways to avoid actually withdrawing from your retirement plan. Essentially, you’re using your retirement funding as a loan to yourself, and you even pay the interest on your loan back to your own 401(k). However, any money you borrow for the loan loses the chance for continued tax-deferred growth within the plan, so it’s still an option of last resort.
The IRS allows 401(k) loans, but employers are not obliged to offer them. You’ll have to check directly with your provider to see if 401(k) loans are offered. If so, you can generally borrow the lesser of $50,000 or half the vested value in your account. Loans must be paid back within five years unless used for the purchase of a primary residence. If you leave your employer for any reason while you’ve still got an outstanding loan, the balance becomes treated as a distribution, subject to taxes and penalties like any other 401(k) withdrawal.
Borrow Against Your Home
According to U.S. Census Bureau data, in the fourth quarter of 2019, about 65% of Americans owned their own homes. If you fall into this category, you might have a great source of capital right under your nose. Using your home as collateral, you can take out a home equity loan to get the emergency cash you need.
The terms of a home equity loan can vary from lender to lender. However, many home equity loans have maturities of between five and 15 years, and rates are currently 5.10%. Choosing a home equity loan over a 401(k) withdrawal can help you avoid taxes and penalties and still allow your retirement funds to grow.
Use a Personal Loan
A personal loan is a way to borrow money at a rate that’s usually much less than borrowing on a credit card. It’s also a way to avoid taking money out of your retirement accounts. Generally, personal loans are unsecured, so you won’t have to put up any collateral. However, you will have to qualify on the merits of your credit score. This will affect your interest rate as well.
The personal loan market is booming and incredibly competitive. You can comparison shop and apply for personal loans online with many lenders. Usually, these loans have no fees other than interest charges, and you can receive a decision on your application the same day you apply.
Cash-Out Mortgage Refinance
If you’re looking for a silver lining during the current economic pullback, it’s falling interest rates. Starting from an already low level in 2019, mortgage rates have continued to fall, in some areas to 50-year lows. In fact, rates fell so low that lenders had to raise them to stem the demand from homeowners refinancing their mortgages. Rates are likely to remain low and may even trend lower.
With a cash-out mortgage refinance, you benefit in two ways. First, you may be able to refinance your home loan at a lower rate, which means you’ll pay a lower interest rate for years to come. Second, you can actually take money out as cash during the process, which can act as a cash flow substitute for withdrawing money from your 401(k). Bear in mind that with a cash-out refinance, the money you “take out” is added to your loan, so you are still borrowing that money. For example, if you have $100,000 equity in your house and take $20,000 out as cash during the refinance process, your new loan will be for $120,000.
0% Credit Card Loan
Generally, you should avoid taking out loans or cash advances from your credit cards. However, if you have a short-term financing need, a 0% balance transfer offer might make sense. Many issuers provide balance transfer checks that you can pay to yourself and deposit right into your bank, providing you with immediate liquidity.
Zero-percent balance transfer offers are full of terms and restrictions, so be sure to read the fine print before you agree to one. For starters, no “0%” balance transfer offer is free. Most balance transfer checks tack on a fee of at least 3%. All of these offers also have an expiration date, at which point the rate can jump to 15% or even more. If you can’t afford to pay back what you borrow within a relatively short time period, often from six months to 15 months, then you’ll be saddled with very high-interest debt. Use these offers with caution.
Bottom Line on Withdrawing Retirement Funds Early
Withdrawing money early from your retirement accounts carries heavy financial consequences, but sometimes the benefit outweighs the cost. 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 withdrawing from your 401(k) or IRA is important, too. Don’t use your retirement fund to pay off credit card debt or for expenses like a wedding or a car — retirement funds are not savings for a rainy day.
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Morgan Quinn contributed to the reporting for this article.