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Originally Posted On : https://www.empower.com/the-currency/money/can-withdraw-401k-ira-penalty-free

 

 

Key takeaways

401(k) withdrawals are often subject to heavy penalties and additional taxes. Check out a few rules and options to consider before withdrawing.

 

401(k) plans and other tax-advantaged retirement savings accounts are common ways to save for retirement.

Every year, millions of Americans contribute to these long-term savings vehicles. Sometimes, unplanned circumstances force people to withdraw funds from their 401(k) early.

Can you withdraw money from a 401(k) early?

Yes, you can withdraw money from your 401(k) before age 59½. However, early withdrawals often come with hefty penalties and tax consequences.

If you find yourself needing to tap into your retirement funds early, here are rules to be aware of and options to consider.

401(k) withdrawal rules

The IRS allows penalty-free withdrawals from retirement accounts after age 59½ and requires withdrawals after age 72. (These are called required minimum distributions, or RMDs). There are some exceptions to these rules for 401(k) plans and other qualified plans.

The costs of early 401(k) withdrawals

Early withdrawals from an IRA or 401(k) account can be expensive. Generally, if you take a distribution from an IRA or 401(k) before age 59½, you will likely owe:

• Federal income tax (taxed at your marginal tax rate).
• 10% penalty on the amount that you withdraw.
• Relevant state income tax.

The 401(k) can be a boon to your retirement plan. It gives you flexibility to change jobs without losing your savings. But that can start to fall apart if you use it like a bank account in the years preceding retirement. In general, it’s a good idea to avoid tapping any retirement money until you’ve reached age 59½.

How much tax do I pay on an early 401(k) withdrawal?

The IRS levies a 10% additional tax on early withdrawals from a 401(k) plan.1 This tax is designed to encourage long-term participation in employer-sponsored retirement plans.

You may also owe both federal income tax and relevant state tax.

What to ask yourself before making a withdrawal from your retirement account

Retirement may feel like an intangible future event, but hopefully, it will be your reality some day. Before you take any money out, ask yourself an important question:

Do you need the money now?

Rather than putting money away, you are actually paying it forward.

If you are relatively early on in your career, you may be single and financially flexible. But your future self may be neither of those things. Pay it forward. Do not allow lifestyle inflation to put your future self in a bind.

Try to think of your retirement savings accounts like a pension. People working towards a pension tend to forget about it until they retire. There is no way they can access it before retirement. While that money is locked up until later in life, it can become a powerful resource in retirement.

Consider contributing to a Roth IRA, if you qualify for one.

Because contributions to Roth accounts are after tax, you are typically able to withdraw from one with fewer consequences. Some people find the ease of access comforting.

Keep a few factors in mind:

• There are income limits on contributing to a Roth IRA.
• You will still be taxed if you withdraw the funds early or before the account has aged five years.

What are penalty-free exceptions for an early 401(k) or IRA withdrawal?

Sometimes, there are circumstances when it’s difficult to avoid tapping into retirement accounts — 10% penalty or no.

Before you pay the penalty, be aware that there are several circumstances under which the IRS grants exceptions to the 10% penalty rule.2 These exceptions may make it possible for you to tap your retirement savings in a time of need without having to pay the extra penalty.

Although these exceptions may enable you to avoid the 10% penalty, you will still owe income tax on any premature IRA or 401(k) distributions.

Also, remember these are broad outlines. Anyone wanting to tap retirement funds early should talk to their financial advisor.

401(k) hardship withdrawals

Some 401(k) plans will allow what is called a hardship withdrawal, with education expenses sometimes falling under this clause. Expenses eligible for a hardship withdrawal will vary depending on your 401(k) plan administrator. Make sure you know what will qualify under your specific plan. Some providers do not allow hardship withdrawals at all.

Basically, hardship withdrawals mean you’re able to take money from your 401(k) before age 59½, but most of the time you will still be hit with the penalty. There are a few exceptions, but education expenses are usually not one of them.

Medical expenses or insurance

If you incur unreimbursed medical expenses that are greater than 10% of your adjusted gross income in that year, you can pay for them out of an IRA without incurring a penalty.

For a 401(k) withdrawal, the penalty will likely be waived if your unreimbursed medical expenses exceed 7.5% of your adjusted gross income for the year.

Family circumstances

If you are required by a court to provide funds to a divorced spouse, children or dependents, the 10% penalty can be waived.

Series of substantially equal payments

If none of the above exceptions fit your individual circumstances, you can begin taking distributions from your IRA or 401(k) without penalty at any age before 59½ by taking an early distribution. This allows you to take a series of specified payments every year. The amount of these payments is based on a calculation involving your current age and the size of your retirement account. And remember, even though you can take distributions without penalty, you’re still subject to income taxes at your ordinary tax rate.

Also, once you start, you must continue taking the periodic payments for five years, or until you reach age 59½, whichever is longer. In addition, you will not be allowed to take more or less than the calculated distribution, even if you no longer need the money. So be careful with this one!

Education

You are allowed to take an IRA distribution for qualified higher education expenses, such as tuition, books, fees and supplies. This distribution is still subject to income tax, but there won’t be an additional penalty.

For instance, if you want to go back to graduate school and you need the money, you can decide to tap your retirement fund for tuition. The rule also allows you to apply this exception to your spouse, children or their descendants.

Keep in mind this is for IRAs, 401(k) plans or other qualified plans that are subject to a different ruleset.

First-time home purchase

You can take up to $10,000 out of your IRA penalty-free for a first-time home purchase. If you are married, your spouse can do the same.

Also, first-time home is defined loosely. For the purposes of the IRS, it is your first-time home if you have not had ownership interest in a home for the past two years.

Just like the education exclusion, you can also tap this option for the benefit of your family. Your children, parents or other qualified relatives may receive the same $10,000 for their purchases, even if you’ve used this benefit for yourself previously or already own a home.

First-time home purchases or new builds may also be considered eligible for a hardship withdrawal from your 401(k). Again, the 10% penalty will still likely apply.

What if you only need the money short term?

Suppose you’re not interested in paying any taxes at all. You can still use your 401(k) to borrow money via a loan. The interest goes to you, the loan isn’t taxable, and it wouldn’t show up on your credit report. Here’s how it works.

401(k) loan

The IRS allows you to borrow against your 401(k), provided your employer permits it. It’s important to note that not all employer plans allow loans, and they are not required to do so. If your plan does allow loans, your employer will set the terms.

The maximum loan amount permitted by the IRS is $50,000 or half of your 401(k) plan’s vested account balance, whichever is less.

During the loan, you pay principal and interest to yourself at a couple points above the prime rate, which comes out of your paycheck on an after-tax basis. Generally, the maximum term is five years. However, if you use the loan as a down payment on a principal residence, it can be as long as 15 years. Sometimes, employers will require a minimum loan amount of $1,000.

The benefits of such a loan are:

• You do not need a credit check.
• Nothing appears on your credit report.
• Interest is paid to you instead of a bank or credit card company. The interest rates are usually lower than what you could receive elsewhere, and the paperwork is not complex.

Now the downsides:

• If you leave your employer (or are fired), your loan is generally due right away, usually within 60 to 90 days.
• If you can’t pay it back, you will be assessed a penalty by the IRS.
• You are not able to borrow from an old 401(k) plan.
• You cannot borrow from an IRA if you transferred your 401(k) funds to an IRA.
• Taking a 401(k) loan depletes your retirement principal and will cost you any compounding that your borrowed funds would have received.

IRA rollover bridge loan

There is one final way to “borrow” from your 401(k) or IRA on a short-term basis. You can roll it over into a different IRA. You are allowed to do this once in a 12-month period.

When you roll an account over, the money is not due into the new retirement account for 60 days. During that period, you can do whatever you want with the cash.

However, if it’s not safely deposited in an IRA when time is up, the IRS will consider it an early distribution. You will be subject to penalties in the full amount.

This is a risky move and is not generally recommended. However, if you want an interest-free bridge loan and are sure you can pay it back, it’s an option.

What are the pros and cons of a 401(k) withdrawal vs. a 401(k) loan?

Pros and cons of 401(k) withdrawal vs. 401(k) loan

 

401(k) withdrawal

401(k) loan

Pros

• You’re not required to pay back withdrawals and 401(k) assets.

• You don’t have to pay taxes and penalties when you take a 401(k) loan.
• The interest you pay on the loan goes back into your retirement plan account.
• If you miss a payment or default on your loan from a 401(k), it won’t impact your credit score.

 

Cons

• If you’re under the age of 59½ and take a traditional withdrawal, you won’t get the full amount because of the 10% penalty and the taxes you will pay up front as part of your withdrawal.

 

• If you leave your current job, you may have to repay your loan in full in a very short time frame.
• If you can’t repay the loan, it’s considered defaulted, and you’ll owe both taxes and a 10% penalty if you’re under 59½.
• You also lose out on investing the money you borrow in a tax-advantaged account, so you’d miss out on potential growth.

The bottom line

There are several ways you can withdraw from your 401(k) or IRA penalty free. Still, we recommend not touching your retirement savings until you are retired.

Compounding can have a significant impact on helping to maximize your retirement savings and extending the life of your portfolio. You lose out on that when you take early distributions.

We understand that it’s always possible for unforeseen circumstances to arise before you reach retirement. Being aware of the exceptions allows you to make informed decisions and possibly avoid paying extra fees and taxes.

To take control of your finances, a good place to start is by stepping back, getting organized, and looking at your money holistically.

You can use Empower’s free financial tools to:

• Track your net worth over time.
• Review all your investments in one place.
• Make sophisticated projections for the success of your retirement plan.