What You Need to Know About Removing Money From Your 401(k) Early
Early 401(k) withdrawals can be subject to more than just income taxes
As your 401(k) account grows in value, it can be tempting to get your hands on your hard-earned savings. Many people find it difficult to view their retirement savings as being off limits, particularly as more immediate needs and want arise.
But whether you need a down payment for a new house, college tuition for your kids, or even cash for an unexpected financial emergency, it's important to proceed very carefully when you're considering a 401(k) withdrawal. Every 401(k) withdrawal means sacrificing important benefits of your hard-earned previous plan contributions. They may even lead to higher income taxes and additional penalties.
401(k) Account Withdrawal Rules and Penalties
One of the most helpful benefits of a 401(k) plan is that each contribution brings tax benefits. Not only is your contribution tax deductible today, but your contributions to your account are also growing tax-deferred. But these tax benefits are only applicable when you abide by the rules of the plan, and these rules limit everything from how much you can contribute to the plan annually to when you can withdraw funds from the plan penalty-free.
With rare exceptions, all traditional 401(k) withdrawals are taxable as ordinary income, although Roth 401k assets are treated differently. In an ideal situation, you would not withdraw funds from your 401(k) until after you retire. You'll pay income tax on those withdrawals just as you did with each paycheck you earned when you were employed. But many people find that they're in a lower tax bracket in retirement than they were during their working years, and this can add up to some relative tax savings.
But if you withdraw funds from your 401(k) before you reach at least age 59½, you'll owe not only income tax on the amount you withdraw, but those funds are also subject to an additional 10 percent early distribution penalty tax. It is where things get sticky fast. For some people, this can mean cutting the total you withdrew almost in half after paying taxes and penalties! Not only does "losing" that money to taxes today hurt but it will cost your retired self even more.
Exceptions to 401(k) Withdrawal Penalties
That said, there are several exceptions to the 10 percent early distribution penalty that are intended to alleviate some of the financial loss in certain situations. (Check if your 401k plan allows for a hardship withdrawal.) Under the following circumstances, 401(k) withdrawals made before you reach age 59 ½ are exempt from the additional penalty:
- You die, and the account is paid to your beneficiary
- You become disabled
- You terminate employment and are at least 55-years-old
- You withdraw an amount less than is allowable as a medical expense deduction
- You begin substantially equal periodic payments (see Rule 72(t))
- Your withdrawal is related to a qualified domestic relations order
Withdrawals in each of these scenarios would only be subject to ordinary income taxes, not the additional 10 percent penalty, but the withdrawals must be made according to plan rules and with appropriate documentation. Be sure to educate yourself about your plan's requirements before you take such a withdrawal.
Additional 401(k) Early Withdrawal Considerations
In addition to penalties and taxes due upon a 401(k) early withdrawal, you'll lose the potential future investment growth of that retirement plan money. There are annual limits to the amount you can contribute to a 401K plan, so you can’t make up for a previous withdrawal later. Not to mention, it would be much more difficult to save enough to "catch up" on the lost earnings and compound interest.
Although 401(k) loans have their own significant drawbacks, you may want to consider such a loan if you're in a financial pinch and your only option appears to be your retirement money. Even with its drawbacks, a 401(k) loan is generally preferable to an outright 401K withdrawal, although neither is ideal.
Delaying Your 401(k) Withdrawals and RMDs
On the other end of the spectrum, most people can delay receiving distributions from their 401(k) plans and thereby maximize the benefits of their tax-deferred growth until April 1 of the year following the year in which they reach age 70½. After that point, you must withdraw at least your required minimum distribution (RMD) annually.
Your RMD is calculated as your account balance as of the beginning of the year in question divided by your life expectancy as determined by the IRS in its Uniform Life Expectancy table. An exception exists if your spouse is your sole beneficiary and she is more than ten years younger than you.
Like an early withdrawal, not taking your annual RMD comes with a steep penalty. The penalty for not withdrawing your RMD is 50 percent of the difference between what should have been distributed and what was actually withdrawn.