How to Make an Early Withdrawal from Your 401k Account
A 401(k) is an employer-sponsored retirement savings plan with the goal of saving enough that you can make withdrawals in retirement to suit your lifestyle. This money can grow tax-deferred, including employer contributions, while keeping the long-term goal of retirement in mind. Life happens to everyone, and our goals occasionally shift. You may have asked yourself if removing money from a 401k is an option before retirement. The answer to that question is yes. However, if follow-up questions sound something like “can I take money out of my 401k” and, if yes, “what is the most efficient way to do so,” then keep reading.
Taking an early withdrawal from 401k can be a costly option
In a perfect scenario with your 401k savings, you won’t need to take a distribution until you are ready to leave employment behind for the next chapter of your life, which is retirement. Ideally, this will be at least age 59.5 (and in some cases, it could be age 55). Not to be confused with the ages you can generally claim Social Security or Medicare. Those aren’t arbitrary numbers that we decided to make up. Those are the ages outlined by the IRS at which you can begin withdrawing money from retirement plans without paying the 10 percent additional penalty in most cases. I say most cases because there are exceptions to the rule when it comes to withdrawing retirement money without the costly 10 percent penalty, and the rules can differ depending on whether an employee is currently employed or not. The caveat with any of these exceptions is that it could derail financial plans and projections for the future. It is true that accessing your retirement funds may not be prudent. There is the 10 percent penalty, paying income taxes on the amount taken out above the income you are receiving from your employment, potentially selling holdings when the market is down, no longer contributing to the 401k plan, and missing some potential gain because of a balance decrease. However, it may also be true that you may not have another choice. Let’s address the choices you have if you decide to withdraw from retirement assets.
How to take out your 401k early without getting penalized
The money that is withdrawn from a 401k could be subject to the penalty in addition to Ordinary Income tax. If you withdraw from a 401k, you also miss the chance for continued growth.
Request a hardship withdrawal
If certain circumstances are met, you may qualify for what is called a hardship withdrawal. This type of withdrawal allows you to take money from your 401k plan and not be subject to the 10 percent penalty. The IRS defines a hardship as “an immediate and heavy financial need.” Not every 401k plan has been set up to allow for hardship withdrawals, so it is best to talk with your plan administrator to see if this feature is available. It is worth noting that once you take money from your 401k in this manner, you cannot go and put it back when your situation improves. Contributions to your 401k have to come from your payroll deferment or a rollover from another qualified retirement plan. Once you have determined that the hardship withdrawal option is best for you and you are eligible for this type of withdrawal. You will need to fill out the necessary forms, documents, and paperwork requested from your employer. Once that is all in order, you should get a check for the specified amount, less any taxes and fees. Direct deposit may be an option through your 401k provider, but not all provide this as an option for receiving your (hopefully) penalty-free withdrawal. Please be aware that if the distribution is coming from a traditional 401k, you will need to account for Federal (and state when applicable) taxes.
Exceptions to the penalty
You may qualify for a hardship withdrawal under the following circumstances:
- Funeral expenses for you, your spouse, children, or dependents
- Tuition, related educational fees, and room and board expenses for the next 12 months of postsecondary education for you, your spouse, children, dependents, or beneficiary
- Medical care for yourself, your spouse, dependents, or a beneficiary
- Some expenses to repair damage to your primary residence
- Payments necessary to prevent eviction from your principal residence or foreclosure on the mortgage on that home
- Costs directly related to the purchase of your principal residence (excluding mortgage payments)
There is a limit to how much you can withdraw from your 401k with a hardship distribution. My caution here is that we shouldn’t try to outsmart the IRS. If you only need to take a net amount of $6,000, then that is all you should take. Some may not believe that purchasing a new $15,000 snowmobile is truly an emergency and an additional distribution for the difference from your 401k is a worthy cause.
Alternatives to 401k withdrawals
There is an old saying that goes, “there is more than one way to crack an egg.” There is likewise more than one way to access money in your 401k.
Take a 401k loan
Another way of getting money out of your 401k is through a 401k loan. Not every company offers this feature. It’s best to check with your employer or plan administrator to see if this is an option for you. The key highlights for 401k loans are:
- The amount you can take as a loan is determined by your vested account balance and is typically 50 percent of the account balance (up to a loan amount of $50,000).
- Instead of a permanent reduction in your account balance, you pay back the loan through paycheck deductions.
- Loans are typically paid back with interest within five years.
- The loans are paid back with after-tax dollars.
- If you leave employment with an outstanding 401k loan balance, you will have to pay it back promptly, or it will count as a distribution and could incur the 10 percent penalty.
Substantially Equal Periodic Payments (SEPP)
The final method we will cover on getting money out of your 401k is by the Substantially Equal Periodic Payments (SEPP) method. This option will allow you access to the funds without the additional 10 percent penalty. These payments are not available under an employer-sponsored retirement plan but rather an Individual Retirement Account (IRA). These payments are not a lump sum payment as with other 401k withdrawal options. When starting SEPP payments, you must continue the payments for either five years or when you reach age 59.5, whichever is longer. Meaning, if you start a SEPP at 58, you will have to keep it going for another five years until you are 63. The payment amount is calculated using one of the following methods: Fixed Amortization, Fixed Annuitization, or Required Minimum Distribution. Each method differs in the amount of the payment and is beyond the scope of our discussion here.
401k withdrawal vs 401k loan: pros and cons
If you have made it this far through the different methods of accessing retirement funds, the next logical question might be which is better, a 401k loan or withdrawal?
The money is yours, and there is no need to take a loan from anyone (including yourself). You’re not required to pay anything back, which frees up monthly cash flow. There are different options when taking money out (SEPP or Lump Sum).
You will have taken money that is for retirement and could be subject to a 10 percent penalty. You will lose potential compound interest: 10 percent gain on $50,000 is better than 10 percent gain on $15,000. If you’re still working, an early distribution could bump you up to a higher tax bracket than is desirable.
You are not diminishing your assets, rather borrowing from them. You don’t have to pay taxes on the amount you borrow, and any interest paid goes back to your retirement account balance. There is no impact to your credit score if you miss a payment because 401k loans are not reported to a credit bureau.
If you leave your job, the loan balance may need to be paid in full. If not repaid, the balance could count as an early distribution and be subject to taxes and the 10 percent penalty. You will also forfeit the opportunity to invest new money because of the focus you now have on paying your 401k loan within the required time period.
Can I take out money from 401k?
The answer is that you likely can take money from your 401k. There is a great deal of information to address on which option is best for you. Another question to consider is if there are options outside of your 401k that are available to you. With so many options and so much information, it doesn’t take long to feel discouraged on which option is best for you. The good news is one of our experienced Financial Guides can unpack this information and help make an unbiased decision that works for you.