401(k) Withdrawal Rules

Understanding the ins and outs of 401(k)s is crucial when making a retirement plan. A 401(k) offers an excellent opportunity for employees to put away part of their income each month tax-free.

Plus, getting a contribution match from your employer can significantly boost your retirement savings bottom line. But understanding the rules surrounding 401(k) withdrawals equally important.

In this guide, we’ll dive deep into the rules of 401(k) withdrawals, how they work, and what they mean for your financial goals. By understanding these rules, you can make the most of your tax-free retirement savings and reduce income tax while avoiding unexpected tax penalties.

After all, the primary objective of saving for retirement is to maximize your savings while keeping your tax rate as low as possible.

What is an Early Withdrawal?

Taking money out of your 401(k) retirement account before you reach the age of 59 1/2 constitutes an “early withdrawal.” These withdrawals typically trigger a 10% early withdrawal penalty on the total amount of money you withdraw, in addition to more taxable income for the year in which you make the withdrawal.

When you make an early withdrawal from your 401(k), those funds are no longer invested, and thus, they cease to earn compound interest. It’s not just about the immediate 10% penalty or the added tax expenses — the real impact is on your long-term retirement savings. Your account balance can suffer in the long run, putting you at a disadvantage in retirement.

Understanding the potential implications for your retirement savings if you make an early withdrawal is critical. The reality is that early withdrawals can significantly affect your financial future and should be treated as a last resort.

Reasons for Early Withdrawal

In certain circumstances, making an early withdrawal from your traditional 401(k) does not lead to a tax penalty, though it will almost always lead to income tax. In these scenarios, you’ll have to prove heavy financial need to be eligible, and your situation will need to qualify as a penalty exception in the IRS’ view.

Each situation has unique implications, and understanding these nuances will allow you to make an informed decision that aligns with your financial goals. Remember that these rules are not the same for all types of retirement accounts, like traditional IRAs or Roth IRAs, which have their own rules.

Hardship Withdrawal

A hardship withdrawal gives you early access to retirement funds during a severe financial crisis. Whether you’re facing eviction, foreclosure, or other qualifying emergencies, these withdrawals can be a financial lifeline.

But remember that even though hardship distributions can help during financial crises, they are still subject to income tax, and if you’re under 59.5, the infamous 10% early withdrawal penalty.

Suffer Disability

A disability that significantly affects your life expectancy or hampers your ability to work may make you eligible for penalty-free withdrawals from your 401(k) retirement account.

Taking a distribution based on a life-altering disability way to maintain your financial security until you’re of age to claim Social Security.

Higher Education Expenses

Believe it or not, your 401(k) funds can also serve your higher education goals. You can withdraw from your 401(k) to pay for higher education expenses, but you’ll pay both income tax and the 10% penalty. The 10% penalty can be waived if you were to withdraw from your IRA to fund higher education expenses.

Leave Your Job

If you decide to leave your job after age 55 (or age 50 for certain public safety employees), you may be allowed to make penalty-free withdrawals from your 401(k) — according to the Rule of 55. It’s a nuance of the 401(k) rules, but not IRA rules, that can help you access your retirement funds if you’re planning an early exit from your job.

Funeral Expenses

Covering funeral expenses if you die can be emotionally and financially draining for your loved ones. If your beneficiaries need money to cover such costs, a penalty-free cash out of your 401(k) funds might be an option.

Unreimbursed Medical Expenses

If you have unreimbursed medical expenses that exceed a certain percentage (currently 7.5%) of your adjusted gross income, your 401(k) can provide financial support. In this case, you can withdraw from your 401(k) without any penalties.

However, it’s important to note specific rules surrounding what qualifies as a medical expense, so double-check the IRS website or with a CPA before making any decisions. There are also other options like Healthcare Savings Accounts (HSAs) that may be more advantageous for covering costs related to medical emergencies.

What Are Required Minimum Distributions?

Once you reach a certain age, the IRS mandates that you take Required Minimum Distributions (RMDs) from your traditional 401(k). The RMDs refer to the minimum amount that must be withdrawn each year from your employer’s plan. As of 2023, these distributions must start by April 1 after the year in which you turn 73.

If you’re an account owner or a participant in a qualified retirement plan, make sure to start your required distributions by April 1st after the year in which you turn 73. By understanding and planning for RMDs, you can avoid costly tax penalties and maximize your retirement savings.

401(k) Withdrawal Rules

Understanding the specific rules associated with 401(k) withdrawals is critical to making the best decisions about your retirement savings. Here are some of the fundamental policies to keep in mind:

• You must be at least 59 1/2 before you can start withdrawing from your 401(k) penalty-free.
• The IRS mandates Required Minimum Distributions (RMDs) starting at 73 as of 2023. This means you need to start taking monthly distributions from your tax-deferred savings at that time and declare the distributions as taxable income.
  • If you have a Roth 401(k), starting in 2024, you won’t need to worry about RMDs, since required distributions will no longer be required from Roth accounts.
• If you decide to withdraw your money early, you’ll owe income tax plus a 10% early withdrawal penalty. Your total income tax burden will depend on your adjusted gross income for that tax year, which accounts for all of the other income you had — not just the 401(k) withdrawal.
• Various time frames and conditions stipulated by your plan administrator may apply before you can initiate a withdrawal. There may be vesting schedules outlined by your plan sponsor, which also indicate a waiting period before you can touch employer contributions.

Remember, getting to grips with these rules is crucial to successfully navigating the 401(k) landscape and avoiding fees and extra costs leading up to retirement age.

Can A Company Refuse Early Withdrawals?

Every retirement plan comes with its own set of rules and regulations. Some plans may be more strict than others regarding early withdrawals. For instance, some companies might not allow early withdrawals, while others may allow hardship withdrawals or even 401(k) loans that you can pay back through periodic payments at a given interest rate.

Understanding the specifics of your plan is essential to ensuring you make the right decisions for your financial future. Take the time to read through your plan documents and ask questions if anything is unclear. Early distributions should always be considered a last resort.

The Bottom Line

The world of 401(k) withdrawal rules can seem daunting, but you can navigate toward a successful retirement by understanding how these rules work.

If you’re considering withdrawing from your 401(k), engaging with a financial advisor is highly recommended. They can guide you through the process, explain potential implications, and help you make the best decisions based on your situation.

If you want to initiate a 401(k) rollover, work with a trusted partner like Capitalize.

We’re dedicated to making your financial journey smooth and successful. Find out how we can help you build your retirement savings.