401(k) plans are designed to help you save for retirement. Therefore, the IRS discourages withdrawals from 401(k) plans until you turn 59 ½. If you are trying to withdraw early from your 401(k) – before you reach the magical age –you will have to pay a steep price for it if you don’t tread carefully.
In this article, we’ll examine the three early 401(k) withdrawal consequences and offer ways to avoid early withdrawal penalties.
Consequences of Early 401(k) Withdrawal
If you withdraw from your 401(k) before you are 59 ½, you will have to pay federal as well as state income taxes, plus a 10% early withdrawal penalty. The three consequences of early withdrawal are:
- Penalty: If you withdraw money from your 401(k) before age 59½, you are charged a 10% penalty when you file your tax return. For example, if you withdraw $20,000, a penalty of $2,000 will be assessed when you file your tax.
- Withholding of taxes: The IRS generally withholds 20% of a 401(k) early withdrawal for taxes. For example, if you withdraw $20,000, you’ll only get $16,000, and $4,000 will be withheld for tax. You may get some of the amounts back as a tax refund if the withheld tax is more than your tax liability.Note: Between income taxes and penalty, your effective take home could be $14,000 for a total early withdrawal amount of $20,000.
- Less money for the future: When you withdraw early, you are essentially pulling out money that could have earned good market returns and helped you accumulate more wealth.
How to Avoid Early 401(k) Withdrawal Penalties
There are ways to avoid early 401(k) withdrawal penalties, and they include the following:
- Check whether you qualify for a hardship withdrawal: A hardship withdrawal is a withdrawal of funds from a retirement account to pay for an immediate or large financial need. If you qualify for a hardship withdrawal, you won’t be penalized for 401(k) early withdrawal. The following qualify for a hardship withdrawal:
- Money to buy a house, and not for mortgage payments
- Medical bills for you, your spouse, or dependents
- Money to avoid eviction or foreclosure
- College fees, tuition, and room and board for you, your spouse, or your dependents Funeral expenses
- Certain home repair costs
- Check whether you qualify to get an 10% tax penalty exception: The IRS generally waives the early 401(k) withdrawal penalty in the following situations:
- When you agree to receive SEPPs (substantially equal periodic payments). Here you choose to take a series of equal payments from your account that begin once after you stop working. These payments continue for life and are usually the same amount for at least five years or until you reach 59½ (whichever is longer). This is quite a complex process, so it’s best to consult a qualified financial advisor first.
- When you have to cash out your 401(k) in a divorce. If the court orders you to cash out a 401(k) to split with your ex-spouse, the early 401(k) withdrawal penalty might not apply.
- When you leave your job. If you leave your work when you turn 55 or later, you may get an exception to the 10% penalty.
Other exceptions for penalty-free early 401(k) withdrawals are:
- You are or become disabled.
- After your death, the payments went out to your beneficiary or estate.
- You rolled over your 401(k) into another qualified retirement plan within a certain period.
- You adopted or gave birth to a child during the year.
- The money was used to pay an IRS levy.
- You were auto-enrolled in a 401(k) or overcontributed to it, and you want out.
- You are a disaster victim and IRS has granted relief.
- You were called to active duty in the military.
- Consider converting your 401(k) to an IRA: The withdrawal rules for individual retirement accounts (IRAs) are different from 401(k)s. So, if you convert your 401(k) to an IRA before making the early withdrawal, you might be able to avoid that 10% 401(k) early withdrawal penalty.
- Consider a Personal 401 k Loan : If your Plan allows for loans you are generally allowed to borrow 50% of your plan’s assets up to $50,000. This loan can be paid back over a five year period with minimal interest AND the interest is going back to your Plan. So if you are going to remain employed for five years, consider the loan procedure – you will avoid taxes and the Penalty. If for any reason you can’t pay back the loan in the five-year window, THEN the remaining unpaid balance will be considered a distribution and the taxes will be due on that amount. If the five-year window pushes you past the 59 ½ age, then any unpaid amount should not incur the penalty. So, make sure that you really need the money you withdraw because it’s not possible to get the money back once you pay those taxes.
It’s actually never a good idea to cash out a 401(k) for frivolous expenses like buying a car. If you have to take an early withdrawal from your 401(k), let it be only for true emergencies. Early 401(k) withdrawals attract taxes and penalties, plus stunt the growth of your retirement saving – is it worth it?
Rick Pendykoski is the owner of Self Directed Retirement Plans LLC, a retirement planning company based in Goodyear, AZ. He has over three decades of experience working with investments and retirement planning, and over the last ten years has turned his focus to self-directed ira accounts and alternative investments. If you need help and guidance with traditional or alternative investments, call him today (866) 639-0066.