A 401(k) is a retirement savings plan made available through your employer. As an employee, you can contribute up to a certain maximum amount of money every year, and that money is tax-free until you withdraw it. If you withdraw earlier than age 59 1/2, you must pay mandatory penalties.
Typically, early withdrawal is considered a last resort.
However, there are exceptional circumstances that allow you to take out your money without fines.
Read on to learn more about 401(k) plans, the consequences of early withdrawal, and the instances in which you do not have to pay early withdrawal fines.
Understanding early withdrawal from 401(k)
There are two types of 401(k) plans: traditional 401(k) and Roth IRA.
As you work, you make annual contributions to your retirement savings account, and when you reach age 59 1/2, you are eligible for withdrawing those savings.
The traditional plan means that the money you set aside increases free of taxes. As a result, you pay fewer taxes leading up to withdrawal. Afterward, however, you are expected to pay monthly taxes on that sum. With Roth, your money also grows tax-free, but the taxes you pay leading up to withdrawal remain the same. But once you take out the money, you do not have to pay taxes on it during retirement.
The 401(k) is an employer-sponsored plan, and early withdrawal qualifications vary between employers. Taking out the money can have consequences in the future, so always take your time before deciding to do so.
The penalty for early withdrawal is approximately 10 percent, plus regular income taxes on the accumulated money. As of this year, this rule applies to all 401(k) holders.
Using your retirement savings early should be a last resort. If you need supplemental funds, you can apply for a personal loan. This particular type of loan, while smaller in volume than other types, can be used to fund home renovations, weddings, travel, and emergencies.
Early 401(k) withdrawal consequences
Financial penalties for early withdrawal exist to discourage workers from dipping into their funds earlier than necessary.
The consequences that you can expect to face are threefold:
One: Taxes. The IRS typically withholds up to 20 percent of the early withdrawal amount. You may qualify for tax refunds and get some of it back, but that is not always the case.
Two: IRS penalties. Remember, you must pay a 10 percent fee for withdrawing from your 401(k) if you're under the age of 59 1/2.
Three: Less money for your future. The primary purpose of 401(k) plans – whether traditional or Roth – is to encourage long-term savings for the next chapter of your life. Whenever you take money from those accounts, you're leaving yourself with fewer funds to sustain a decent quality of life once you've retired.
The 401(k) loan option
Despite the name, no lenders, borrowers, or credit history checks are involved in a 401(k) loan. This term communicates that you're able to access a specific portion of your 401(k) savings as if it were a loan. If you do so, you're required to pay it back until your plan is "restored." In other words, until your total savings are back to where they were before you took out the loan. Essentially, you're transferring your own money from one place to another by lending to yourself.
This option is recommended over early withdrawal. So is hardship withdrawal.
Before going this route, there are some considerations to keep in mind.
One: Most plans allow one loan at a time, but some plans permit up to two loans. You must settle the first loan before you can take out a subsequent one.
Two: You will be required to make regularly scheduled repayments. These repayments can come in the form of salary deductions.
Three: Depending on the plan, you may need to get consent from your spouse before taking out a loan.
Four: You must pay back the loan within five years. If the loan is going toward your home, however, the grace period is extended.
Five: The funds you use to pay yourself back is after-tax income.
The hardship withdrawal option
A hardship withdrawal from a 401(k) is the most notable deviation from the norm regarding advanced withdrawal. To qualify for this exemption, an individual's circumstances must meet two qualifications. Your reasons for cashing out your 401(k) should be due to serious and immediate financial need. Similarly, the amount of money withdrawn should be only what is necessary to cover the cost of those needs and nothing more. And, as usual, much paperwork is required.
Circumstances that qualify for hardship withdrawal include, but are not limited to the following.
One: Unreimbursed medical expenses. This can either be for yourself, your spouse, or for any dependents.
Two: Payments to prevent eviction from your home or a foreclosure on a principal residence mortgage.
Three: Funeral or burial expenses. Again, this applies to a parent, spouse, child, or another dependent.
Four: A down payment on a principal residence or covering repair costs to fix damage to that residence.
Five: College tuition and related educational costs for the next 12 months for you, your spouse, dependents, or non-dependent children.
It is crucial to note that once you withdraw for any of these reasons, you cannot replace that money. It differs from company to company, but some employers won't allow you to contribute money to your 401(k) for a certain period afterward.
On average, you can take up to $50,000 from the 401(k), though this threshold also varies from employer to employer. Although, as outlined by the CARES Act passed in 2020, individuals can withdraw up to $100,000. This only applies to those directly affected by COVID-19.
Can you make an early 401(k) withdrawal without penalties?
Yes, in some cases, you don't have to pay penalties for early withdrawal.
One: You are in debt for medical expenses that exceed a certain percentage – as defined by the IRS – of your adjusted gross income. Withdrawals must occur in the same year you received the medical bills.
Two: You must, by court order, give a portion of your 401(k) assets to your former spouse as part of a divorce decree.
Three: You become totally and permanently disabled, as evidenced by collecting disability payments from an insurance company or Social Security.
Four: You are a member of the military and must report for active duty.
Five: You give birth or adopt a child. You can take out up to $5,000 during the year that the birth or adoption occurs, not before. This money is to be used to cover related expenses, as outlined by the SECURE Act.
People withdraw from their 401(k) when they are in need of additional funds. Instead of potentially putting your retirement on pause or even in jeopardy, there are steps you can take along the way to prevent this from becoming necessary. That said, allow us to introduce the Point Card.
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