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401(k) Withdrawals Explained

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Many people wonder when they can access the money in their 401(k). Generally, financial advisors suggest you avoid tapping your nest egg before the official retirement age, but there can be situations when you need to access those funds early. You may be dealing with a medical or financial emergency, or maybe you’ve decided to retire early. Unfortunately, you can run into significant penalties if you take money out of your 401(k) early. That doesn’t mean you should never make a 401(k) withdrawal, but it’s best to weigh the taxes and penalties you’ll pay against your immediate need for the money. If you want to retire early or need to take money out of your 401(k) to cover expenses, then keep reading to learn everything you need to know about 401(k) withdrawals.

A lot of people ask, “Can I withdraw from my 401(k)?” You can, but you may face taxes and penalties for doing so — whether you take a small amount or end up cashing out your 401(k) entirely. Withdrawals are subject to income tax. The contributions you made to your 401(k) were likely to have been before tax since you probably had a Traditional 401(k) account. As a result, the IRS makes you pay income tax when you withdraw because you never paid tax on the money going in.

If you choose to withdraw money from your 401(k) before reaching the age of 59½, you’ll be making what’s known as an ”early” distribution. When you make an early distribution, you’ll also generally pay an additional 10% early withdrawal penalty. Some exceptions apply to this rule, but generally the IRS imposes an early withdrawal penalty to discourage people from withdrawing money from their retirement savings early.

You’ll pay taxes in almost all withdrawal situations, but there are a few scenarios that allow you to make an early 401(k) withdrawal without a penalty.
  • Medical: in the amount of unreimbursed medical expenses.
  • Disability: in the event of the total and permanent disability of the participant.
  • Death: after the 401(k) account holder passes away.
  • Corrective distributions: when you’ve accidentally overcontributed to a 401(k) and have to take money out to meet the contribution limits.
  • Divorce: If you’re ordered to pay out part of your 401(k) to a spouse upon divorce, known as a Qualified Domestic Relations Order (QDRO).
  • Levy: due to an IRS levy (which permits the legal seizure of property to pay a tax debt) of the plan.
These are a few common exceptions, but there are also others that apply less frequently. One other way to avoid the 10% early withdrawal penalty is to qualify for a hardship distribution — if your plan allows for it. A hardship distribution may be possible if you have a financial hardship and need the money. Like most exceptions, there are requirements to qualify. You can only make hardship distributions if the distribution meets both of the following criteria:
  • You’re withdrawing because of an immediate and heavy financial need.
  • You’re withdrawing no more than the amount required to meet that financial need, including any taxes that result from the withdrawal
Your employer will determine if you meet the criteria based on your plan terms. If you’re unsure if you’ll qualify for a 401(k) hardship withdrawal, do a gut check: is the expense necessary? For example, consumer purchases like electronics or jewelry aren’t an immediate and heavy financial need. Typical hardship examples can include:
  • Select medical expenses.
  • Costs associated with a funeral or burial.
  • Funds to stop an eviction or foreclosure from occurring.
  • Necessary home repairs after a natural disaster occurs.
There are also some other conditions that must be met in order for you to take a hardship distribution:
  • You’ve already obtained any other currently available distributions and nontaxable plan loans that might be available to you.
  • You can’t make contributions to your plan for at least six months after the hardship distribution occurs.

Whether an early withdrawal is right for you depends on your situation. To help you think about it, here’s a few pros and cons of making early withdrawals to consider:

Pros

  • You can finance big expenses such as home repairs, medical bills or college tuition if you need the money.
  • You can avoid taking on debt if you need to cover a financial emergency.

Cons

  • You’ll pay taxes and penalties on your withdrawal, so you’ll likely get 70% or less of the money you take out.
  • When you withdraw money from your 401(k), you lose the growth potential that can come with keeping your money invested.

If you don’t want to make a 401(k) withdrawal, you may have another option: 401(k) loans.

A 401(k) loan is when you borrow money from your 401(k) account. This can be useful because 401(k) loans are usually quick to apply for, have flexible cost and repayment terms, and usually don’t have a major impact on your retirement savings.

There’s a catch: the maximum you can withdraw is 50% of your account balance, or $50,000 — whichever amount is lower. Like other loans, you’ll have to repay whatever amount you withdraw plus interest. In this case, the interest is to cover the assumed growth of your 401(k) if you had not withdrawn the amount of your loan. This might seem confusing, but ultimately you’re just repaying yourself.

As a result of the COVID-19 crisis, many people have experienced temporary financial hardships and emergencies. Congress passed the CARES Act to allow more flexibility when making an early withdrawal to cover your financial needs. The CARES Act eliminates the 10% early withdrawal penalty as long as you meet certain requirements. These include being diagnosed with COVID-19, or experiencing financial consequences from a lost job or reduced hours. In most cases, one-third of the money you withdraw will be counted as taxable income for each of the next three years. If you need to make a withdrawal, check if you qualify under the CARES act to avoid an early withdrawal penalty.

If you’re starting a new job, chances are you’ll find yourself with some paperwork that has the word “rollover” stamped all over it. A rollover is a transfer of money from one retirement account to another. It’s different from a withdrawal — because the money is staying in a retirement account, you typically won’t pay taxes or penalties on rollovers.

A rollover can happen after you leave a job and choose to rollover your employer-sponsored account to a new 401(k) or IRA.Don’t worry, taking money out of a 401(k) during a rollover transaction isn’t taxable, but you will need to report it on Form 1099-R. You can roll over most distributions, but there are a few exceptions.

In an ideal world, you won’t need to cash out your 401(k) and you’ll leave your retirement savings contributions alone until you reach retirement age. However, there are scenarios when you may consider a withdrawal before reaching the age of 59 ½. Normally you should expect to pay both income tax and a 10% penalty on these early withdrawals — but there are situations when you can avoid that penalty. Keep in mind that any withdrawn money also loses the opportunity to grow for you. For these reasons, most financial advisors suggest 401(k) withdrawals as a last resort.

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