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Understanding 401k Withdrawal Rules

Key Points

  • While it’s possible to withdraw money from your 401k account before you reach retirement, there may be tax and penalty consequences to doing so.
  • Before withdrawing money from your 401k account early, you should consider other options.
  • For many people, a better alternative is to take out a 401k loan instead.

401k plans, IRAs and other tax-advantaged retirement savings accounts are common ways to save for retirement, and millions of Americans pour money into them every year.

It’s generally wise to avoid withdrawing money from your 401k early, as there are often hefty penalties and taxes to consider for early withdrawals.

Sometimes, however, unplanned circumstances force people to withdraw funds from their 401k early. If you find yourself in a place where you need to tap your retirement funds, here are some rules and options to consider.

Rules for Withdrawing Money from Your 401k

Generally, if you take a distribution from an IRA or 401k before age 59 ½, you will likely owe both federal income tax (taxed at your marginal tax rate) and a 10% penalty on the amount that you withdraw, in addition to any relevant state income tax. That tends to add up. Given these consequences, withdrawing from a 401k or IRA early is usually not ideal.

If you find yourself in a situation where you do need to withdraw funds from your 401k or traditional IRA early, there are a few circumstances in which the 10% penalty might be waived.

Keep in mind that although these exceptions may enable you to avoid the 10% penalty, you will still owe income tax on any premature IRA or 401k distributions. Also remember that these are broad outlines. Anyone wanting to tap retirement funds early should talk to their financial advisor.

Calculate It: 401k Early Withdrawal Calculator

Early 401k Withdrawal Options

Following is a breakdown of the main early 401k withdrawals options and whether or not a penalty applies to these withdrawals.

401k Hardship Withdrawals

Some 401k plans will allow what is called a “hardship withdrawal,” with education expenses sometimes falling under this clause. It is important to note here that expenses eligible for a hardship withdrawal will vary depending on your 401k plan administrator. Make sure you are aware of what will qualify under your specific plan. Some providers do not allow hardship withdrawals at all.

You’ll also likely be charged the 10% fee for taking funds from your 401k early for most types of hardship withdrawals. There are a few exceptions, but education expenses are usually not one of them. Basically, hardship withdrawals mean you’re able to take money from your 401k before you reach age 59 ½, but most of the time you will still be hit with the penalty.

Medical Expenses or Insurance

If you incur unreimbursed medical expenses that are greater than 10% of your adjusted gross income in that year, you are able to pay for them out of an IRA without incurring a penalty.

For a 401k withdrawal, the penalty will likely be waived if your unreimbursed medical expenses exceed 7.5% of your adjusted gross income for the year.

Family Circumstances

If you are required by a court to provide funds to a divorced spouse, children, or dependents, the 10% penalty can be waived.

Series of Substantially Equal Period Payments (SSEP)

If none of the above exceptions fit your individual circumstances, you can begin taking distributions from your IRA or 401k without penalty at any age before 59 ½ by taking a 72t early distribution. Named for the tax code that describes it, a 72t early distribution allows you to take a series of specified payments every year. The amount of these payments is based on a calculation involving your current age and the size of your retirement account. Visit the IRS’ website for more details.

The catch is that once you start, you have to continue taking the periodic payments for five years, or until you reach age 59 ½, whichever is longer. Also, you will not be allowed to take more or less than the calculated distribution, even if you no longer need the money. So be careful with this one!

Education (IRA Only)

You are allowed to take an IRA distribution for qualified higher education expenses, such as tuition, books, fees and supplies. This distribution is still subject to income tax, but there won’t be an additional penalty.

For instance, if you want to go back to graduate school and you need the money, you can decide to tap your retirement fund for tuition. The rule also allows you to apply this exception to your spouse, children or their descendants. Keep in mind this is for IRAs — 401ks or other qualified plans are subject to a different ruleset.

Read More: 529 Plan vs. Roth IRA: Which is Better for College Savings?

First-Time Home Purchase

You can take up to $10,000 out of your IRA penalty-free for a first-time home purchase. If you are married, your spouse can do the same. Also, “first-time home” is defined pretty loosely. For the purposes of the IRS, it is your first-time home if you have not had ownership interest in a home for the past two years.

Just like the education exclusion, you can also tap this option for the benefit of your family. Your children, parents or other qualified relatives may receive the same $10,000 for their purchases, even if you’ve used this benefit for yourself previously or already own a home.

First-time home purchases or new builds may also be considered eligible for a “hardship withdrawal” from your 401k. Again, the 10% penalty will still likely apply here.

Coronavirus-Related Withdrawals

The coronavirus has presented us all with some unique challenges, and many people have been feeling the financial impacts. The 2020 CARES Act included several ways to offer relief to retirement savers. RMDs were suspended for 2020, allowing individuals to defer taking distributions from retirement accounts if desired. For those who already took RMDs in 2020, they were actually able to return those funds to their IRA or 401k and push any further distributions into 2021.

There were also relaxed rules around early distributions and flexibility for loans and special withdrawal allowances for retirement savers in 2020. The early withdrawal penalty of 10% is back in 2021. Income on withdrawals will count as income for the 2021 tax year.

However, the COVID-Related Tax Relief Act of 2020, passed in December, allows for relief to retirement plan withdrawals made because of qualified disasters. To qualify, taxpayers must have lived in a qualified disaster area and suffered financial loss because of that disaster.

401k Loan Options

Suppose you’re not interested in paying any taxes at all. Here are a couple of options to consider.

1. Borrowing Against Your 401k

The IRS allows you to borrow against your 401k, provided your employer permits 401k loans. It’s important to note that not all employer plans allow loans, and they are not required to do so. If your plan does allow loans, your employer will set the terms. The maximum loan amount permitted by the IRS is $50,000 or half of your 401k’s vested account balance, whichever is less.

During the loan, you pay principle and interest to yourself at a couple points above the prime rate, which comes out of your paycheck on an after-tax basis.

Generally, the maximum term is five years. However, if you use the loan as a down-payment on a principal residence, it can be as long as 15 years. Sometimes, employers will require a minimum loan amount of $1,000.

Benefits of a 401k Loan

  • You do not need a credit check and nothing appears on your credit report.
  • Interest is paid to you instead of a bank or credit card company.
  • The interest rates are usually lower than what you could receive elsewhere.
  • The paperwork is not complex.

Drawbacks of a 401k Loan

Now the downsides.

  • If you leave your leave your employer (or are fired), your loan is generally due within 60 to 90 days. If you can’t pay it back, you will be assessed a penalty by the IRS.
  • You are also not able to borrow from an old 401k plan. You can only borrow from a 401k if you are still working for the employer where that 401k resides.
  • You cannot borrow from an IRA if you transferred your 401k funds to an IRA.
  • Taking a 401k loan depletes your retirement principal and will cost you any compounding that your borrowed funds would have received.

2. IRA Rollover Bridge Loan

There is one final way to “borrow” from your 401k or IRA on a short-term basis: You can roll it over into a different IRA using what’s called an IRA rollover bridge loan.

You are allowed to do this once in a 12-month period. When you roll an account over, the money is not due into the new retirement account for 60 days. During that period, you can do whatever you want with the cash.

However, if it’s not safely deposited in an IRA when time is up, the IRS will consider it an early distribution. You will be subject to penalties in the full amount.

This is a risky move and is not generally recommended. However, if you want an interest-free bridge loan and are sure you can pay it back, it’s an option.

Early 401k Withdrawal Considerations

There are many valid reasons for dipping into your retirement savings early. However, try to avoid the mindset that your retirement money is accessible.

Retirement may feel like an intangible future event, but hopefully, it will be your reality some day. So before you take any money out, ask yourself: Do you actually need the money now?

Think of it this way: Rather than putting money “away,” you are actually “paying it forward.” If you are relatively early on in your career, your present self may be unattached and flexible. But your future self may be none of those things. Pay it forward. Do not allow lifestyle creep to put your future self in a bind.

With all this talk of 10% penalties, and not touching the money until you’re retired, we should point out that there is a solution if you feel the need to be able to access your retirement funds before you reach age 59 ½ without penalty: Contribute to a Roth IRA, if you qualify for one.

Because contributions to Roth accounts are after tax, you are typically able to withdraw from one with fewer consequences. Keep in mind that there are income limits on contributing to Roth IRAs and that you will still be taxed if you withdraw the funds early or before the account has aged five years. But some people find the ease of access comforting.

When Can You Withdraw from Your 401k or IRA Penalty-Free?

There are a number of ways you can withdraw from your 401k or IRA penalty-free. Still, we recommend not touching your retirement savings until you are actually retired.

Compounding is a huge help when it comes to maximizing your retirement savings and extending the life of your portfolio. You lose out on that when you take early distributions. To see how much compounding can affect your 401k account balance, check out our article on the average 401k balance by age.

We understand that it’s always possible for unforeseen circumstances to arise before you reach retirement. Being aware of the exceptions allows you to make informed decisions and possibly avoid paying extra fees and taxes.

Frequently Asked Questions

Can I withdraw money from my 401k account before I retire?

Yes, but there may be tax and penalty consequences to doing so.

What are these consequences?

In most instances you’ll pay a 10% penalty tax on top of ordinary income taxes are your current marginal tax rate.

Are there any exceptions to these consequences?

Yes, there are a number of exceptions. These include hardship withdrawals, medical expenses and education, family circumstances and first-time home purchases.

Are there alternatives to withdrawing money early if I really need it?

Yes, the main alternative being a 401k loan. There’s no credit check, nothing appears on your credit report and the interest is paid to you instead of a bank.

The Bottom Line

To take control of your finances, a good place to start is by stepping back, getting organized, and looking at your money holistically. You can take a few actions now to get yourself on the right track.

  1. Download 65 Ways to Retire Smart, an actionable guide with insights from fiduciary financial advisors. The guide is free.
  2. Sign up for the Personal Capital Dashboard. Millions of people use these free and secure professional-grade online financial tools. You can use them to see all of your accounts in one place, analyze your spending, and plan for long-term financial goals.
  3. Consider talking to a fiduciary financial advisor for more detailed guidance on your retirement saving strategies.

Get Started with Personal Capital’s Free Financial Tools

The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting or investment advice. You should consult a qualified legal or tax professional regarding your specific situation. Keep in mind that investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money.

Any reference to the advisory services refers to Personal Capital Advisors Corporation, a subsidiary of Personal Capital. Personal Capital Advisors Corporation is an investment adviser registered with the Securities and Exchange Commission (SEC). Registration does not imply a certain level of skill or training nor does it imply endorsement by the SEC.

Debbie Macey is a Senior Financial Advisor at Personal Capital.
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