Making an early withdrawal from your 401(k) might sound like a tempting idea initially — after all, it is your money. But once you know the ramifications, you may feel differently.
There are two types of 401(k)s: traditional and Roth. The traditional option allows you to set aside dollars for retirement on a tax-deferred basis, meaning that your taxable income is reduced by the amount of the money you set aside in a calendar year. Your money grows tax-deferred until the tax code allows you to begin making penalty-free withdrawals after age 59 ½.
With the Roth option (not offered by all employer plans), your money also grows tax-deferred, but your contributions are made on an after-tax basis. That means your current taxable income is not reduced, but you don’t owe taxes on the withdrawals in retirement as long as you’ve had the account for at least five years.
Matching contributions from an employer (if applicable) are deposited in a traditional 401(k) account and you’ll pay taxes on any distributions taken, even if you opt to contribute your own funds to a Roth 401(k).
Here’s what you need to know if you’re considering taking an early withdrawal from your 401(k) and some alternatives that may prove to be better options for your financial situation.
Withdrawing money from a 401(k): Taking cash out early can be costly
An unexpected job loss, illness or other emergencies can wreak havoc on family finances, so it’s understandable that people may immediately think about taking a withdrawal from their 401(k). Tread carefully as the decision may have long-range ramifications impacting your dreams of a comfortable retirement.
Taking a withdrawal from your traditional 401(k) should be your very last resort as any distributions prior to age 59 ½ will generally be taxed as income by the IRS, plus a 10 percent early withdrawal penalty. This penalty was put into place to discourage people from dipping into their retirement accounts early.
Withdrawals of Roth contributions are generally tax- and penalty-free, as long as the withdrawal occurs at least five years after the tax year in which you first made a Roth 401(k) contribution and you’re 59 ½ or older. This is because the dollars you contribute are after-tax. Be careful here because the five-year rule supersedes the age 59 ½ rule. If you didn’t start contributing to a Roth until age 60, you would not be able to withdraw funds tax-free for five years, even though you are older than 59 ½.
You can withdraw funds from your Roth 401(k) prior to age 59 ½ if you haven’t met the five-year rule noted above, but with a caveat. Because your withdrawal must include both your own contributions and earnings on those contributions, your withdrawal must be prorated based on the percentage each constitutes in your portfolio. So although any contributions you’ve made are withdrawn tax-free, earnings on those contributions would be taxed as regular income and subject to a 10 percent tax penalty.
If your employer’s plan allows it, a hardship withdrawal from a traditional or Roth 401(k) to address “an immediate and heavy financial need” is another way to gain access to your money. This type of withdrawal permanently reduces your portfolio’s balance and you’re taxed as noted above.
Tax rules do not allow you to pay this money back or “put it back” in your account after the hardship has passed and your financial situation improves. After taking such a withdrawal, some companies bar you from contributing to the plan for six months or more, further compounding your loss of retirement savings especially if you are missing out on a company match.
For those contemplating a hardship withdrawal, remember your 401(k) is meant to provide income in retirement and should not be tapped for other reasons unless your situation is truly dire.
What type of situation qualifies as a hardship?
The following limited number of situations rise to the level of “hardship,” as defined by Congress:
- Unreimbursed medical expenses for you, your spouse or dependents
- Payments necessary to prevent eviction from your home or foreclosure on a mortgage of principal residence. (Regular mortgage payments do not constitute a hardship.)
- Funeral or burial expenses for a parent, spouse, child or other dependent
- Purchase of a principal residence (down payment) or to pay for certain expenses for the repair of damage to a principal residence
- Payment of college tuition and related educational costs for the next 12 months for you, your spouse, dependents or non-dependent children
Your plan may or may not limit withdrawals to the employee contributions only. Some plans exclude income earned and or employer matching contributions from being part of a hardship withdrawal.
In addition, IRS rules state that you can only withdraw what you need to cover your hardship situation, though the total amount requested “may include any amounts necessary to pay federal, state or local income taxes or penalties reasonably anticipated to result from the distribution.”
“A 401(k) plan — even if it allows for hardship withdrawals — can require that the employee exhaust all other financial resources, including the availability of 401(k) loans, before permitting a hardship withdrawal,” says Paul Porretta, a compensation and benefits attorney at Troutman Pepper in New York.
However, the passage of the SECURE Act 2.0 in late 2022 created new conditions for emergency withdrawals (more below).
401(k) loans are generally considered to be a better option than a hardship withdrawal if given the choice, since you’re essentially borrowing from yourself. Not all plans allow loans — although it is a fairly common feature — so be sure to check with your employer. Even when they’re allowed, there are specific rules you must follow to avoid penalties and taxes.
The amount you can borrow is defined in your employer’s plan, but typically it’s limited to 50 percent of the vested value of your account up to a maximum dollar amount (typically $50,000, save for exceptions made as part of the CARES Act). There is usually a loan minimum as well. You can find out how much you can borrow by viewing your account online, speaking to a plan representative or contacting your HR department.
Key considerations with 401(k) loans
- Some plans permit up to two loans at a time, but most plans allow only one and require it be paid off before requesting another one.
- Your plan may also require that you obtain consent from your spouse/domestic partner.
- You will be required to make regularly scheduled repayments consisting of both principal and interest, typically through payroll deduction.
- Loans must be paid back within five years, unless borrowing for the purchase of a primary residence, which allows for a longer payback period.
- If you leave your job and have an outstanding 401(k) balance, you’ll have to pay the loan back within a certain amount of time or be subject to tax and early withdrawal penalties.
- The money you use to pay yourself back is done with after-tax dollars.
Although getting a loan from your 401(k) is relatively quick and easy, the benefit of paying yourself back with interest will likely not make up for the return on investment you could have earned if your funds had remained invested.
Another risk: If your financial situation does not improve and you fail to pay the loan back, it will likely result in penalties and interest.
Impact of a 401(k) loan vs. hardship withdrawal
Before making a decision on which course to pursue, consider the financial impact of each. For example, consider this scenario developed by 401(k) plan sponsor Fidelity:
- Taking a loan: A 401(k) participant with a $38,000 account balance who borrows $15,000 will have $23,000 left in their account.
- Taking a withdrawal: If that same participant takes a hardship withdrawal for $15,000 instead, they would have to take out a total of $23,810 to cover taxes and penalties, leaving only $14,190 in their account.
That’s a significant difference simply to access the same $15,000. Also, due to the time value of money and the loss of compounding opportunities, taking out $23,810 now could result in tens of thousands less at retirement, maybe even hundreds of thousands, depending on how long you could let the money compound.
Other alternatives to taking a hardship withdrawal or loan from your 401(k)
Before you decide to take money out of your 401(k) plan, consider the following alternatives:
- Temporarily stop contributing to your employer’s 401(k) to free up some additional cash each pay period. Be sure to start contributing again as soon as you can, since foregoing the employer match can be extremely costly in the long run.
- Transfer higher interest rate credit card balances to a lower rate card to free up some cash or take advantage of a new credit card offer with a low interest rate for purchases (or to access cash).
- Take out a home equity line of credit, home equity loan or personal loan.
- Borrow from your whole life or universal life insurance policy. Some permanent life insurance policies allow you to access funds on a tax-advantaged basis through a loan or withdrawal, generally taken after your first policy anniversary.
- Take on a second job to temporarily increase cash flow or tap into family or community resources, such as a non-profit credit counseling service, if debt is a big issue.
- Downsize to reduce expenses, get a roommate and/or sell unneeded items.
Can you make an early withdrawal from a 401(k) without penalty and for what reasons?
If any of these apply to you, you can likely access your money early without having to pay the penalty, though you won’t get out of paying any taxes on the distribution:
- You become totally and permanently disabled as evidenced by collecting disability payments from an insurance company or from Social Security.
- You are in debt for medical expenses that exceed a certain percentage (as defined by the IRS) of your adjusted gross income (withdrawal must be made in the same year the medical bills were incurred).
- You are required by court order to give a portion of your 401(k) assets to your former spouse as part of a divorce decree.
- There’s an IRS levy on the plan.
- You are a member of the military reserve called to active duty.
- There’s a birth or adoption of a child. The SECURE Act of 2019 allows up to a $5,000 withdrawal within (but not prior to) one year of the birth or adoption finalization to pay for related expenses.
- You can wait until age 55, provided you are no longer employed by the company with whom the 401(k) is affiliated AND you left that employer during or after the calendar year in which you reached age 55.
- You plan to take funds with Substantially Equal Periodic Payments (SEPP). SEPP is allowed only after you have separated from service and set up a payment schedule to withdraw money in substantially equal amounts over the course of your life expectancy. This exception is available to anyone regardless of age, but once you begin this type of distribution you are required to continue it for five years or until you reach age 59 ½, whichever is longer. There is a chance that you could run out of money before the end of the distribution period, especially if you use too high a rate of withdrawal or if the market declines substantially during your SEPP period.
Special rules resulting from the coronavirus pandemic
The CARES Act of 2020 gave employers the option to amend their 401(k) plans to allow “investors who are impacted by the coronavirus to gain access to [more] of their retirement savings without being subject to early withdrawal penalties and with an expanded window for paying the income tax they owe on the amounts they withdraw,” per The Security and Exchange Commission’s (SEC) Office of Investor Education and Advocacy (OIEA).
“An employer could amend their plan by allowing coronavirus-related distributions but not increasing the 401(k) loan limit,” according to Porretta.
The SEC’s OIEA guidance on the CARES Act allowed “qualified individuals impacted by the coronavirus pandemic to pay back funds withdrawn over a three-year period (2020, 2021 and 2022), and without having the amount recognized as income for tax purposes.”
New emergency withdrawals allowed by the SECURE Act 2.0
Among many other provisions, the SECURE Act 2.0 added the ability for employers to offer retirement plans that provide the ability to make emergency withdrawals:
- Employers can add a provision to their plan that allows non-highly compensated employees to save for emergencies, up to $2,500 per year. These savings are not counted as part of the regular contribution amounts in the retirement plan and can be used by the employee at their discretion.
- Employees can withdraw up to $1,000 from their plan each year for unforeseeable emergency needs. These distributions will not be liable for the 10 percent bonus penalty, if applicable. The employee can take just one emergency distribution per year, and the money can be repaid within three years.
- Employers are now able to add provisions to their plans that allow withdrawals without the 10 percent bonus penalty for terminally ill employees or victims of domestic abuse.
- Those taking distributions due to disasters after December 27, 2020 will not be subject to the 10 percent bonus penalty for early withdrawal as long as they do not withdraw more than $22,000, their principal residence is in the federally defined disaster area and they suffer an economic loss from the disaster.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.