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Withdrawing money early from your 401(k)—that is, before you turn 59?—comes fraught with financial risks. It’s universally considered a bad idea to prematurely siphon funds from a nest egg that can help support your lifestyle in retirement or protect you in your senior years from the high cost of healthcare.
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Can you withdraw money from a 401(k) early?
While as a practical matter you can definitely do it, withdrawing money early from your 401(k)—that is, before you turn 59?—comes fraught with financial risks. While tax penalties are the most serious, you’ll also reduce the potential for your investments to compound over time. And it’s universally considered a bad idea to prematurely siphon funds from a nest egg that can help support your lifestyle in retirement or protect you in your senior years from the high cost of healthcare.
Penalties of a 401(k) early withdrawal
Let’s start with why 59? is the magic number. That’s the age at which you can start withdrawing from your 401(k) without being subject to a penalty. Do so before you reach that age, and you’ll be generally charged a 10% penalty by the Internal Revenue Service (IRS), in addition to the applicable income taxes on the amount withdrawn.
How to calculate early withdrawal penalties on a 401(k) account
Let’s say you take an early 401(k) withdrawal of $50,000. Get ready for the ouch: Your penalty alone will eat up $5,000 of your distribution.
When calculating the penalty, you’ll also want to consider the income taxes you’ll owe. If you have a Roth 401(k), you’ve made contributions over time from after-tax income, so you don’t owe any taxes. With a traditional 401(k), you’ve lowered your taxable income up front, which means that, with any withdrawal (premature or during retirement), you’ll pay standard income tax on the amount you took out.
When should you make a 401(k) early withdrawal?
Good question and unfortunately there may not be a good answer. However, there are situations where it could be advisable: for example, to wipe out a sizable amount of high interest debt. It’s tricky, though. If your interest charge savings outweighs the tax penalties for taking an early withdrawal, keep in mind that you’ve also robbed yourself of the potential for that money to produce the good kind of interest—compound interest on your 401(k) contributions that works in your favor over time.??
Financial emergencies where no other options are available could also qualify as a reason—but notice how we said “could” instead of “should” And the chances are you’ll have more alternatives than you think—from taking out a personal loan or home equity line of credit (also known as a HELOC) to using a reverse mortgage to cash out your home’s value. Do you have an emergency fund? Now’s the time to look at tapping it. You’ll also want to itemize high-value assets you can sell off—perhaps you could sell a luxury car and trade down to a less costly one.
How to avoid the early withdrawal penalty
That’s easy if you think about it: Just. Don’t. Do it.
Otherwise, there is a clever (and quite legal) twist, and that’s to borrow from your 401(k). Again, treat this as an emergency option, such as to pay off high interest debt. Depending on what your employer's plan allows, you can take out as much as 50% of your savings, up to a maximum of $50,000, within a 12-month period. Just remember that in most cases you’ll need to pay back the loan within five years. You’ll also need to pay interest, often a point or two above the prime rate.
You can also check to see if you qualify for a hardship withdrawal. The general IRS definition isn’t necessarily helpful: You can take a hardship withdrawal “because of an immediate and heavy financial need, and limited to the amount necessary to satisfy that financial need.” So where does that apply, exactly, in the eyes of Uncle Sam?
You’d be surprised. Drill down and you’ll find the IRS lists qualifying expenditures ranging from college tuition to home damage, along with family funeral expenses. It even includes “costs directly related to the purchase of an employee’s principal residence,” though it must be stressed that you have to prove hardship, and can’t use the money for mortgage payments. Consult a tax professional, financial advisor or your employer’s plan administrator to see if you qualify. Empower offers specialized financial advisors for retirement to help you in strategizing the best approach.
New emergency withdrawals allowed by the SECURE Act 2.0
Passed in 2022, the act lists six circumstances under which the 10% penalty can be waived:
- Federally declared disasters
- Terminal illness
- Domestic abuse
- Unforeseen or immediate financial emergencies
- Emergency savings accounts linked to pensions
- Qualified long-term care distributions
How long does it take to cash out a 401(k) after leaving a job?
Usually, funds are available within a few days. But you’ve got to roll over those funds into another 401(k), IRA, or other retirement account within 60 days.
Special rules resulting from the coronavirus pandemic
As a result of the 2022 CARES Act, an employee who retired during the pandemic, but is hired back afterwards will be considered “unretired,” as the IRS puts it and be subject to the same conditions of any pre-retiree regarding penalties—though they will not be penalized in any way for returning to work.
The IRS also allowed for expanded distribution options and favorable tax treatment for up to $100,000 of coronavirus-related distributions from eligible retirement plans, including 401(k)s and IRAs.
TIME Stamp: Carefully consider the caveats of early withdrawals
It can’t be stressed enough: early 401(k) withdrawals to splurge on big-ticket items is a terrible, horrible, no good, very bad idea. It’s not why these accounts were designed. There are, though, situations when a withdrawal might make sense—for example, if you’ll be wiping out high interest credit card debt that will save you far more in interest payments than the tax penalties you’ll incur.
But again, money taken out of a 401(k) early means that much less to grow your account over time. So in the end, you’ll want to weigh any decision based on financial necessity. Here, a financial advisor can help you make a smart call.
Frequently asked questions (FAQs)
Does my employer have to approve my 401(k) withdrawal?
In certain instances, yes. Many jobs require that the funds are vested—which happens after you pass a certain amount of time as an employee—but that only applies to the funds they put into your account by an employee match, and not the ones you contribute.
How do I avoid 10% tax on my 401(k) withdrawal?
The easiest way to avoid the 10% penalty is to wait until you turn 59?. If you want to avoid taxes altogether (absent of penalties), that’s only possible if you’ve set up a Roth 401(K), which uses after-tax income for contributions.
What qualifies a hardship withdrawal?
In addition to the reasons listed above, foreclosure on a home, eviction, or high out-of-pocket medical expenses. Again, keep in mind that there are many conditions and requirements attached to these withdrawals, so seek professional advice before you pursue this option.
** Empower Personal Wealth, LLC (“EPW”) compensates Time Stamped for new leads. Time Stamped is not an investment client of Empower Advisory Group, LLC.
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