- Withdrawing money from your 401(k) early is not recommended, since the amount is subject to 20% income tax, plus a 10% IRS penalty.
- While it’s hard to avoid the tax, there are ways to avoid the 10% penalty, including a loan and a hardship withdrawal.
- Temporary changes to the rules under the CARES Act may give you more flexibility to make a 401(k) early withdrawal.
When it comes to retiring, conventional wisdom says you should wait until age 59½ to take money out of your 401(k) plan. But what if you need cash before then?
The good news: You can access your 401(k) funds sooner, a process the IRS calls an “early withdrawal.” The bad news: If you do, you usually trigger taxes and a steep penalty — and lose out on years of potential growth for your nest egg.
However, there are exceptions to the rules — and strategies to avoid such dire consequences.
Consequences of a 401(k) early withdrawal
A 401(k) is an employer-sponsored retirement plan. You make regular pre-tax contributions to it – that is, straight off the top of your paycheck — and the money within it grows tax-free.
Because these tax-advantaged accounts are meant to help you save for retirement, the IRS imposes strict rules about when and how you can withdraw your money. Primarily, that you have to be at least 59 years and six months old.
Technically, anyone can withdraw funds at any time — or take a distribution, in IRS-speak — from their 401(k) before they hit that magic age. It’s your money, after all.
But you may not get as much money as you had hoped for. That’s because the withdrawal will be subject to:
- A mandatory 20% federal tax: When you take out money, the plan’s service provider is required to withhold 20% in federal income tax. That means if you withdraw $10,000, you will get $8,000.
- A 10% tax penalty: You will owe a 10% penalty when you file your income tax return — or $1,000 on that $10,000 withdrawal.
Taxes and penalties aren’t the only things to worry about when you tap your 401(k) early. Something that could be even worse — in the long run, at least — is the missed opportunity for that money to grow in your account.
For example, say you withdraw $20,000 when you’re 40 years old. Assuming a 7% annual rate of return, the potential future value of that $20,000 today would be about $110,000 by the time you retire at age 65.
Exceptions to the 401(k) early withdrawal tax penalty
In most cases, you can’t get out of paying taxes on the money you withdraw from a 401(k). But people in some situations can avoid the 10% penalty. The IRS will consider waiving the penalty if any of the following situations apply:
- You become or are permanently disabled: If you are or become disabled for life, you won’t owe the penalty.
- You are dividing assets in a divorce: Withdrawals made to satisfy a court order to divvy up the 401(k) with a former spouse or dependent are penalty-exempt.
- You are a qualified military reservist: You can take penalty-free withdrawals during your service period if you’re called to active duty for at least 180 days.
- You leave your job at age 55: Also known as the rule of 55, this provision allows anyone who retires, quits, or is fired at age 55 to withdraw without penalty.
- You enroll in “substantially equal periodic payments”: With SEPP, you withdraw a specific amount from your 401(k) every year for five years or until you turn 59½, whichever comes later. One catch: This account can’t be the one you have at your current job — it has to be one you’ve kept from a previous employer. Also, if you quit the SEPP plan early, you’ll owe all the penalties, plus interest.
In addition to these events and situations, there are two other main ways to cash out early without a tax penalty: hardship withdrawals and loans.
How 401(k) hardship withdrawals work
The IRS allows anyone to take penalty-free withdrawals if they have an “immediate and heavy financial need.” You can use the money to cover your needs or those of someone else.
You may qualify for a hardship withdrawal if the funds go to:
- Pay for certain medical expenses
- Buy a primary residence
- Cover college tuition, fees, room, and board
- Prevent eviction or foreclosure
- Pay for burial and funeral expenses
- Make necessary home repairs after a disaster
How a 401(k) loan works
Given all the drawbacks of early withdrawals, you might consider borrowing from your 401(k) instead.
In general, you can borrow up to $50,000 or 50% of your vested account on a tax-free basis if you repay the loan within five years. Also, under the CARES Act (see below), you can now borrow up to $100,000 and take an extra year to pay back the money you borrowed.
A 401(k) loan can be a better option than an early withdrawal for a couple of reasons:
- You won’t owe taxes or a penalty on the amount you borrow unless you violate the loan limits and repayment rules.
- If you repay the loan on time, you won’t miss out on years of growth like you would with a withdrawal.
Just one catch: Not all companies allow 401(k) loans. Don’t assume you can take one before checking with your plan’s administrator.
How the CARES Act affects 401(k) early withdrawals
The Coronavirus Aid, Relief, and Economic Security (CARES) Act greatly expanded the hardship withdrawal provision. It allows you to take up to $100,000 out of your account penalty-free if you have experienced a financial hardship due to the COVID-19 pandemic.
You will owe tax on one-third of the withdrawal for each of the next three years unless you elect otherwise (pre-CARES Act, the tax was due all at once). And, if you’re able, you can eventually repay the amount you took out — even if doing so makes you exceed annual 401(k) contribution limits.
Currently, the CARES Act applies only to withdrawals taken during 2020 (unless it is renewed).
The financial takeaway
You can access the money in your 401(k) before the traditional withdrawal age of 59½, but you should weigh the pros and cons of doing so first. Keep in mind that your take-home will only be about 70% of the withdrawal amount after accounting for taxes and the 10% penalty.
If you qualify for an exception or hardship withdrawal, you can avoid the 10% penalty, but you’ll still be on the hook for taxes.
Before you tap your 401(k), use an online calculator to estimate how much you could owe — and the results of keeping your money invested instead.
Finally, no matter what, take out only what you absolutely need right now. Otherwise, you could end up paying a lot in taxes and penalties — and losing years of potential growth — for no good reason.
source article: https://www.businessinsider.com/401k-early-withdrawal