There are moments in life that may require unusual financial steps: bridging the gap between jobs, covering expenses during an unexpected period of unemployment, or facing a family emergency are a few of the possibilities.
If it’s absolutely necessary, withdrawing from your 401(k) early is an option – though it should be viewed as a suboptimal choice and ultimately a last resort.
Here, we’ll walk through how an early 401(k) withdrawal would work in practice, and we’ll also explore some alternatives to borrowing from your retirement plan.
When is a 401(k) withdrawal considered early?
401(k)s are tax-advantaged retirement vehicles, which, unsurprisingly, are best utilized to cover expenses in your retirement years. They can be used for more immediate expenses in certain limited circumstances – but their true purpose is to be used in advanced age after you stop working.
According to current law, any withdrawals from your 401(k) are considered early if you take money out of your plan before you turn 59.5. There are several exceptions to this rule, though this is the basic restriction for most people.
If you don’t fall under one of the specific hardship exemptions for taking money out of your 401(k) early, you might be faced with stiff penalties and taxes, so it’s critical that you understand the consequences of early withdrawal.
How does an early withdrawal work?
To make an early withdrawal, you’d simply contact your 401(k) plan administrator – if you don’t know the company that provides administrative services, it’s likely available on your employer’s human resources website.
Your plan administrator will have you fill out a few forms. Once that’s complete, you’ll receive the requested amount in the account you specify, though there will be tax consequences come the following April.
The tax status of your 401(k) also matters: consequences will vary depending if you’re working with a traditional or a Roth 401(k). In the case of a traditional 401(k), you’ll be subject to tax withholding of 20% on any early withdrawals, while in the case of a Roth 401(k), you won’t need to worry about taxes (since the money has already been taxed on contribution.)
Considerations before taking an early withdrawal
Even though a withdrawal might provide access to some available cash, you’ll also want to think about a few of the knock-on effects:
- Loss of long-term stock market gains. The more you remove from your retirement plan, the more you stand to lose in the form of long-term, compounded gains. This effect is greater the further you are from retirement age; that is, you’ll be giving up more in the long run if you early-withdraw when you’re 35 than if you’re 55.
- You’ll owe taxes. For early withdrawals from traditional 401(k)s, your plan administrator will withhold 20% of any distribution for federal taxes. You might get some of this money back come tax time, but plan to owe somewhere around this percentage amount. If you’re working with a Roth 401(k), your withdrawal won’t be taxed (since you’ve already been taxed on this money.)
- You’ll face a 10% penalty. The standard penalty for a 401(k) early withdrawal is 10%, which means 10% of your gross distribution will go back to the IRS. Note that this penalty is levied in addition to any taxes due, so it’s possible you’ll end up with far less in net cash than your gross distribution number.
Example: Say you were to withdraw $5,000 from your traditional 401(k) at age 40. Assuming no exceptions apply, you’d have $1,000 withheld for taxes and face an additional $500 penalty for withdrawing early – leaving you with a net withdrawal of $3,500.
Can you take a 401(k) early withdrawal without penalties?
Luckily, there are a few ways to avoid a penalty when taking an early withdrawal from your 401(k) plan. Among the most common:
- You turn 55 and separate from your employer. Sometimes called “The Rule of 55”, the IRS offers the opportunity to avoid a penalty if you’ve turned 55 and decide to leave your employer. For certain jobs, like those in public service, the age may even be as low as 50.
- You agree to take substantially equal periodic payments. You can also avoid the 10% penalty assessed on early withdrawal if you agree to “annuitize” your 401(k). In other words, if you put your 401(k) into forced liquidation, you’ll still owe taxes on each of the annual distributions but fortunately avoid any penalties.
- You want to roll over your 401(k). The good news here is that a rollover is not a withdrawal, so long as you roll the money that was in your 401(k) plan to another qualified plan within a specified period of time (typically 60 days).
- Other exceptional circumstances that can help you bypass the 10% penalty:
- You overcontribute to, or automatically enroll in, a 401(k) plan and change your mind within a short time frame.
- You pass away and your estate requests a distribution of funds.
- You become totally and/or permanently disabled.
- You receive dividends from an Employee Stock Ownership Plan or “ESOP.”
- The IRS has placed a levy on the 401(k) plan (you owe back taxes).
- You have unreimbursed medical expenses (those not covered by insurance).
- You are a military reservist called to active duty.
Alternatives to a 401(k) withdrawal
While it may seem inevitable, there are ways to avoid withdrawing from your 401(k) but still receive needed funds.
Instead of withdrawing money for good, you have the option of taking a loan from your 401(k) plan – with, of course, the intent to pay it back later.
While you won’t get away completely unscathed since you have to pay interest on your loan, you’ll at least have the opportunity to repay your retirement plan and make yourself whole in the long run.
You can borrow up to 50% of your 401(k) balance or $50,000, whichever is less. If your 401(k) plan balance is $80,000, you can borrow up to $40,000; if your plan balance is $120,000, your maximum loan is capped at $50,000.
Generally, an employee has five years to pay back their 401(k) loan, but must make at least quarterly payments towards the loan balance.
Those facing severe economic hardship may have the opportunity from their 401(k) plans early – though not all plans offer such an option. Still, if the need is serious and necessary, your 401(k) plan funds can help bridge the gap.
The basis of determining hardship is that the withdrawal must satisfy “…an immediate and heavy financial need…”
This often refers to any of the following needs:
- Medical expenses
- Costs related to the purchase of a principal residence
- Tuition and other education-related expenses
- Funds needed to prevent eviction
- Funeral expenses
- Casualty loss to principal residence causing substantial repair
- The bottom line is that your 401(k) plan isn’t meant to cover any of these expenses, but the funds will be there for you if it’s absolutely necessary.
Temporarily stop contributions
Simply turning off your retirement plan contributions is an easy way to increase monthly cash flow without incurring unnecessary taxes or fees. Yes, you’ll lose the future compounded value of any money you would have contributed to your 401(k) plan, but you also won’t have to borrow from (or deplete) the funds that are already in the plan.
To turn off contributions, you’ll need to contact your 401(k) plan administrator and either fill out a physical form or submit an e-request to have your contribution percentage taken down to zero. It might take a pay period or two to kick in, but you’ll receive a higher share of your gross paycheck going forward.
Increase cash flow
One clear way to increase cash flow is to earn more by working a side hustle or taking on a part-time job. This may not be appealing or possible for everyone depending on personal circumstances, but you should know that even small amounts of additional income can go a surprisingly long way in meeting unexpected obligations or covering an emergency.
Extra cash from a part-time gig can also help reduce the pressure on your 401(k) plan – especially if it can help you take a smaller loan or withdrawal. Of course, before taking on more work, consider the totality of your financial and non-financial circumstances.
Explore a 401(k) rollover instead of taking an early withdrawal
It’s pretty clear that taking an early withdrawal from your 401(k) plan should be considered a last resort; that is, it should be done only if absolutely necessary. If you must withdraw funds, know that you’ll be responsible for taxes and penalties, and you’ll also give up opportunities for long-term growth.
Instead, consider a 401(k) rollover. Recall that 401(k) rollovers are not considered withdrawals, and most of the time, can be completed without any taxes or penalties. Depending on where and how you choose to roll over funds, you’ll likely have different options to access your money.
Here at Capitalize, we’re here to assist with 401(k) rollovers – check out our site and let us help you get started today.