Once you reach age 59.5, you may withdraw money from your 401(k) penalty-free. If you tap into it beforehand, you may face a 10% penalty tax on the withdrawal in addition to income tax that you’d owe on any type of withdrawal from a traditional 401(k). But in some cases, your plan may allow you to take a penalty-free early withdrawal. We’ll cover the 401(k) early withdrawal rules and alternatives to dipping into your retirement savings. We can also help you find a financial advisor who can guide you through your options based on your individual needs.
401(k) Early Withdrawal Rules
Your employer may allow you to take money out of your 401(k) plan before you turn 59.5 if you need to eliminate a substantial financial burden. However, your plan sponsor decides whether it allows hardship withdrawals. It also decides what qualifies as such.
Your plan description or plan document should outline these points clearly. You can also check with your benefits department. However, no law requires companies to permit 401(k) early withdrawals at all. And if you make a withdrawal without approval from your company, you could face a hefty 10% tax penalty on the withdrawal.
But regardless of your age, any withdrawal you make from a traditional 401(k) is subject to income tax at your own rate. Congress put the penalty in place to prevent people from dipping into their retirement savings early.
And though you would still endure the 10% early withdrawal penalty, some plans may permit hardship withdrawals if you need to cover the following debts:
Nonetheless, some 401(k) plans permit penalty-free withdrawals under the following circumstances:
In any case, however, tapping into your 401(k) should be your last resort. You have other options to cover unexpected costs. These may be more suitable. We’ll cover a few below.Take Out a 401(k) Loan
Some companies allow participants to take loans against their 401(k)s. In this case, you’re essentially borrowing money from yourself. So you have to pay the loan plus interest back into your own plan.
The most you can borrow against your 401(k) is the lesser of $50,000 or half your vested account balance. Interest rates usually hover just a few points higher than the prime rate. And you usually have five years to pay it back. In some cases, the term can range as long as 15 years if you use the 401(k) loan to cover a down payment on your principal residence.
So how can borrowing money from your own 401(k) plan be more beneficial than taking an early withdrawal? We list a few advantages below:
Nonetheless, you may run into some pitfalls when securing a 401(k) loan. For starters, the term limits drop drastically if you leave your job for whatever reason. In most cases, you must pay it back within 60 or 90 days or face strict IRS penalties. In order to borrow money from your 401(k), you must still work for the company that administers it.Roth IRA Hardship Withdrawals
If turning to your retirement savings is your last resort and you have a Roth IRA, this is the account you may want to consider tapping into first. The contributions you make into these accounts are taxed before they go in. So the IRS can’t tax your contributions twice.
You can withdraw your contributions from a Roth IRA at any time without penalty. So if your Roth IRA contributions have been large enough to cover your financial burden, it might make sense to withdrawal these first. Again, not the best financial decision. But as a last resort, you’d at least avoid taxes and penalties.
However, it’s important to keep in mind we’re talking about contributions here.
This is the money you put into these accounts via automatic paycheck deduction or a bank transfer you initiated. This is separate from the earnings your contributions make from investment funds, interest, dividends or any other source.
The IRS doesn’t permit you to withdraw any investment earnings on your contributions tax-free unless you meet two requirements. First, you have to be at least 59.5-years-old. Second, your account must have been open for at least five years. You must meet both stipulations before you can make tax-free qualified withdrawals from a Roth IRA.
However, you may qualify for a penalty-free withdrawal if you use it to cover certain hardship expenses or undergo certain situations. The earnings portions of these distributions would still face income taxes at your rate. But you would avoid the 10% early withdrawal penalty. We describe a few below:
Medical Expenses: You can take a penalty-free early withdrawal to cover unreimbursed medical expenses that exceed more than 10% of your adjusted gross income (AGI). The rate is 7.5% if you or your spouse was born before Jan. 2, 1952.
Education: You can withdraw money from your Roth IRA penalty free to pay for qualified higher education expenses. This typically includes tuition, as well as books and supplies required to complete enrollment. The student benefiting from the distribution must also be enrolled at least half-time in a degree program. However, the IRS sets education spending limits on Publication 970.
Buying your first home: If you haven’t owned a home in the past two years, the IRS considers you a first-time homebuyer. You can withdraw up to $10,000 from your Roth IRA earnings penalty free to cover the down payment or closing costs linked to buying a home. However, you must pay these within 120 days of receiving the distribution.
Military: You can take a penalty-free Roth IRA withdrawal if you’re a qualified military reservist called to active duty. Make sure you seek a financial advisor or tax professional for complete details.
Disability: If you become permanently disabled, you may take a penalty-free Roth IRA withdrawal. However, you must prove your disability.
Death: If the account owner dies, the beneficiary can generally make penalty-free withdrawals from their inherited Roth IRA.
It’s also important to note that while you can withdrawal your own contributions from a Roth IRA at any time, this is not the case with a Roth 401(k).
IRA Hardship Withdrawal
Companies that administer 401(k) plans undergo strict government regulations. This is one of the reasons why it’s often difficult for employees to tap into their plans before reaching age 59.5, regardless of the circumstances.
However, the IRS generally allows slightly easier access to savings in a traditional IRA or a Roth IRA. You can make penalty-free early withdrawals from your IRA under the same provisions described above, as they relate to Roth IRAs.
However, you’d still face income taxes on these IRA hardship withdrawals. But they’re generally easier to get penalty-free than they would be from a 401(k). For example, the IRS allows you you to take penalty-free withdrawals from your IRA to cover higher education expenses. But if your 401(k) plan lets you make an early withdrawal to cover the same expenses, you’d likely be struck with the 10% penalty.
You also can roll over your 401(k) funds into a new IRA if you don’t have the latter. However, this can be a risky move. You must follow some strict rules when engaging in this process in order to avoid additional penalties. So it’s best to seek the help of a financial advisor if you choose to go this route.
Series of Substantially Equal Payments (SEPP)
A special section in the tax code allows you to take penalty-free withdrawals from your 401(k) before you turn 59.5. Rule 72(t) permits you to take five substantially equal periodic payments (SEPP). The amount of each would be based on your life expectancy as set by the IRS and calculated via one of the organization’s approved methods.
You must take these throughout the course of five years or until you reach age 59.5, whichever is longer. Keep in mind that you can’t take more or less than the calculated amount based on one of the IRS-approved methods. And you must continue taking them based on the time frame described above. The following briefly explains these IRS-approved methods.
Amortization: The amount of your fixed annual payment is based on the amortization of your account balance throughout the course of a single or joint life expectancy as set on the IRS tables.
Minimum Distribution: Your account balance gets divided by a factor from the IRS single or joint life expectancy tables. So the amounts vary throughout the course of your payment stream.The Takeaway
Once you reach age 59.5, you don’t have to worry about withdrawal penalties. But due to federal regulations, plan sponsors usually establish strict restrictions around 401(k) withdrawals. If your plan allows hardship withdrawals, you’d likely owe a 10% tax penalty. But your plan may waive the penalty in some cases. So it’s important to check in with your benefits department directly. You may also have other options that prove more beneficial. These include 401(k) loans or withdrawals from IRAs and Roth IRAs. The IRS offers a bit more wiggle room when it comes to securing penalty-free withdrawals from these accounts. A financial advisor can also help guide you through options that meet your specific needs and financial situation.Tips on Paying Down Debt
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