For many people nearing retirement age, their 401(k) account is their biggest asset. It represents many years of contributions, along with the earnings these contributions have generated from investments over the years.
When you have all this money sitting around, you may have a time when you want to withdraw funds from your 401(k) before you reach retirement age. Perhaps you are facing an unexpected expense or a financial hardship, or maybe you want to make a big purchase. It is possible to withdraw money from your 401(k) before retirement, but it can be very costly to you, depending on the situation.
Rules for 401(k) withdrawals
The typical rules for 401(k) withdrawals are that you must wait until you are age 59-1/2 before you may begin making withdrawals without penalty. However, most employers have additional rules for their 401(k) plans that allow you to make earlier withdrawals of contributed amounts, but not the earnings from those contributions.
In order to make withdrawals without penalty, you must be in a hardship situation with an immediate financial need, which might include:
- Unreimbursed medical expenses for you, your spouse, or your dependents
- Purchasing or repairing damage to your personal residence
- Payments to avoid eviction from a primary residence or foreclosure on a primary residence
- Paying college expenses or room and board for you, your spouse, or your dependents
- Funeral expenses
- Other types of immediate and substantial financial needs
These early withdrawals will reduce the balance of your account now and will significantly affect your balance at retirement. Withdrawn amounts will not generate any additional earnings between the time of withdrawal and your retirement. Take the long-term financial implications of your early withdrawal into account. In addition, you may have short-term costs in the form of penalties for early withdrawals.
Penalties associated with withdrawals
In general, you must pay a 10% penalty on the amount of your withdrawal if you are not yet 59-1/2 years old. You'll pay this penalty when you file your tax return. You'll also be responsible for any income taxes you owe on the withdrawal amount. If you have a Roth 401(k) account, you will not owe income taxes on the withdrawal, but you may still owe the 10% penalty.
Exceptions to early withdrawal penalties
There are some specific cases in which you can make early withdrawals without having to pay the 10% penalty. However, you still have to pay any income tax due on the withdrawal. These special exception cases include:
- Medical costs that exceed 10% of your adjusted gross income for the year
- You are totally and permanently disabled
- A court order to give money to your child, other dependent, or ex-spouse
- Leaving the workforce when at least 55 years of age
- Setting up "substantially equal" withdrawals (usually based on life expectancy) that must continue for at least five years or until you are age 59-1/2. This is based on IRS rule 72(t)
- You are a military reservist being called to active duty
Borrowing from your 401(k)
Before you withdraw money from your 401(k), consider whether you might be better off borrowing from the account instead. Many employers allow you to borrow up to the lesser of $50,000 or half of your account balance. You pay interest on the loan, but that interest goes back into your 401(k) account. However, keep in mind that if you leave your job, voluntarily or not, the loan will become due immediately. If you do not pay it back, you will face the early withdrawal penalties.
Weigh all factors to make your decision
Overall, when possible, you should not withdraw funds from your 401(k) until you reach retirement age. Even then, you should consider leaving the funds in your account until full retirement age to allow them to continue growing during these years of peak earnings. If you are in a financial emergency and qualify to make a hardship withdrawal, keep the tax implications in mind when planning the amount to withdraw. If you still have working years ahead of you, consider taking a loan instead to avoid the early withdrawal penalty and help replenish your retirement account and limit your financial repercussions.