Economists are fond of saying “there’s no free lunch” and for good reason. Very few things involving money come with no strings attached and if it sounds too good to be true, it almost assuredly is. But one source of “free” money is provided through a 401(k) plan, where an employer will match a portion of your contribution as a perk for being an employee. You still need to show up for work of course, but a 401(k) match is as close to a free lunch as you’re likely to see.
A 401(k) plan is an account that forces us to save because withdrawals aren’t allowed until we reach age 59 ½. Well, that’s not entirely true – early withdrawals from 401(k) accounts are allowed, but you need to meet certain criteria to avoid getting penalized. Tapping a retirement account early is always a less than ideal strategy, but if you have no other alternatives, here’s how to do it effectively.
Not all 401(k) accounts are created equal. All 401(k) vehicles have the same $19,500 contribution limit (plus an extra $6,000 if you’re 50 or older) and the same age minimum for withdrawals. If you withdraw from your 401(k) account early, you’ll be hit not just with taxes on the distributions, but also a 10% early withdrawal penalty.
Businesses set up their 401(k) plans independently and not all plans have the same rules beyond the IRS mandates. For example, some 401(k) plans may not allow early withdrawals at all unless a hardship can be proven. Always consult with your employer first if you’re considering an early withdrawal to make sure it’s even applicable to your situation.
Taxes are unavoidable. If you withdraw from your 401(k), you’ll owe taxes on the amount removed, even if it’s a mandatory distribution like an RMD. Early withdrawals usually have 20% withheld for taxes automatically, so a $50,000 distribution would mean $10,000 gone for taxes and another $5,000 to meet the penalty, leaving you with $35,000. But you can avoid the 10% penalty in some scenarios.
A 401(k) loan enables an account holder to borrow against their balance and repay what they take out with interest. The amount you can borrow (and the rate you’ll pay) varies depending on plan administration, but a 401(k) loan doesn’t count as an early withdrawal. Since you’re only borrowing the money, taxes don’t need to be paid either. However, if you default on the loan, you’ll owe both taxes and the 10% penalty.
The IRS can be a monster, but they won’t penalize you if disaster strikes. A hardship withdrawal can be used if you suffer something unfortunate like property damage from a hurricane or disability from an illness or injury. In order to receive a hardship withdrawal, you must demonstrate what the IRS calls “immediate and heavy financial need.” Additionally, you can only withdraw enough to meet the obligations of the hardship and no more. If you tap the money to pay for damage repairs AND some new skis for yourself, you may find yourself in hot water with the IRS.
(Note: In 2020, legislation was passed allowing a $100,000 penalty-free withdrawal if you were affected by the COVID-19 pandemic. Taxes on these withdrawals can be deferred for up to three years as well).
Hardship isn’t the only way to avoid the 10% penalty on a withdrawal. You may be able to avoid penalty if you withdrawal is used on the following:
- Down payment for first-time home buyer
- College tuition
- Child birth or adoption
- Specific needs for active duty military
Tapping a retirement account should only be an action of last resort. If you can borrow money cheaply from a more traditional source or find savings elsewhere to pay your current obligations, you should seek out those options first. Taking an early withdrawal from your 401(k) isn’t just about taxes or penalties, but also a loss of potential growth.
When you take money out of your retirement account, the money in the account will no longer be compounding alongside the rest of your nest egg. If stocks gain 20% in a year while you’re removing money from your retirement accounts, you’ll get the double whammy of taxes now and a smaller nest egg later. Early withdrawals are sometimes necessary, but always consult with a financial advisor first and make sure it’s truly your best option.
The opinions voiced are for general information only and are not intended to provide specific advice or recommendations for any individual.