Quick Guide: 401(k) Early Withdrawal Penalties

Saving for retirement is a smart move. But sometimes life pushes you to tap into your retirement accounts earlier than expected. Typically, you’ll face a 10% penalty for withdrawing early from a traditional 401(k). The amount you withdraw will also be subject to income tax because you funded the account with pretax assets.

What Is A 401(k) And How Does Early Withdrawal Work?

A 401(k) is a retirement plan designed to encourage savers to build a nest egg for their golden years. Employees can direct a pretax portion of their paycheck into this employer-sponsored retirement plan. In some cases, the employer might match a portion of your contributions.

The goal of tucking tax-deferred funds into a 401(k) is to save for retirement. At age 59.5, you can start taking withdrawals from your 401(k) without a penalty. However, life might throw an unexpected financial situation your way that forces you to take an early withdrawal. And that may come at a price.

Here are the consequences of an early withdrawal:

●      Pay a 10% early withdrawal penalty on withdrawn funds.

●      Pay ordinary income tax on the withdrawn funds.

●      Deplete your retirement savings.

●      Miss out on the opportunity for 100% vesting.

Why Vesting Matters

Vesting indicates the level of ownership an employee has over funds that an employer has contributed to the retirement account. All of the contributions you’ve made to the account are always 100% vested. However, employer contributions might be under a vesting schedule.

A vesting schedule outlines how many years an employee must serve at the company to obtain full ownership of the employer contributions. From the employer’s perspective, vesting schedules promote employee retention.

For example, you might only be entitled to the account balance tied to your own until you reach 5 years of service. Once you work at the company for 5 years, you’re entitled to the funds contributed by the company as well. If you only work at the company for 3 years, you aren’t fully vested and might not be able to pull out all of the funds in this employer-sponsored account.

Penalty-Free Reasons To Cash Out A 401(k) Early

The good news is that the tax code is specifically set up to allow for some penalty-free reasons to tap into the funds. While you still have to pay taxes on withdrawals, the right reason could help you avoid paying the early withdrawal penalty.

1. Hardship Withdrawal

The IRS allows account owners to access 401(k) funds through hardship withdrawals without a penalty. Typically, consumer purchases won’t count as a hardship withdrawal. But if you can prove a heavy and immediate financial need, like covering medical bills, you might qualify for this type of distribution.

Some of the reasons that you might qualify for a hardship withdrawal include:

●      Medical bills

●      Funds to avoid a foreclosure

●      Funeral expenses

●      Repair costs for home damage

While you might avoid the early withdrawal penalty, you cannot avoid paying taxes on the withdrawal. Plus, you might lock in investment losses when you pull your funds out of the account prematurely.

2. Rollovers

You have the option to roll over the funds in your 401(k) into another retirement plan or IRA. Typically, you have a 60-day window to move the funds.

Rolling over the funds might be a good option if your retirement savings strategy has changed. For example, if you move employers, you might want to roll your 401(k) into a different provider.

3. Life Changes

Life tends to throw unexpected events your way. If you find yourself in a season of change, you might be able to tap into your 401(k) without a penalty.

Here are some allowable reasons to make a penalty-free withdrawal from your 401(k):

●      You develop a permanent and total disability.

●      The account holder dies, which means the funds can be distributed to beneficiaries.

●      You give birth or adopt a child, with a limit of $5,000 for the year.

●      You pay the IRS a levy.

●      You’re the victim of a natural disaster, if the IRS grants relief.

●      You’re a military reservist placed on active duty.

If you’re facing a pressing financial need, you might find what you need in your 401(k). Of course, it’s usually a good idea to use this loophole as a last resort. When you withdraw funds, you’re breaking into your nest egg before retirement.

How To Withdraw Your 401(k) Early

If you want to make an early withdrawal from your 401(k), the first step is to investigate your eligibility for a penalty-free withdrawal. While you can look at the tax code yourself, it’s usually best to consult a tax professional about whether you qualify.

Of course, you can still make a withdrawal if you don’t qualify. But avoiding the early withdrawal penalty makes a withdrawal more palatable.

Once you’re confident about your eligibility to avoid the penalty, or not, it’s time to reach out to your plan’s administrator. They’ll be able to help you pull out the funds.

Alternatives To Cashing Out A 401(k)

If you aren’t convinced that cashing out your 401(k) is the right move, there are other options to consider. You can avoid hefty penalties and taxes by banking on an alternative.

Here are a few other ways to get your hands on the funds your need:

●      Start an emergency fund: If you don’t have an immediate financial concern, consider starting an emergency fund now. When you run into an unexpected situation, you can fall back on your emergency savings instead of a 401(k).

●      Convert your 401(k) to an IRA: When you convert your 401(k) into an IRA, you’ll have more withdrawal options. For example, qualified first-time home buyers can withdraw up to $10,000 without a penalty from their IRA to purchase their first home. And those with an IRA can use their funds to cover qualified higher education expenses. 

●      Take out a personal loan: Most personal loans don’t have strings attached to how you spend the funds, but you may pay closing costs and interest on the loan. Consider a personal loan with reasonable interest rates and terms.

●      Use a credit card: A credit card isn’t an ideal choice, especially if you don’t know if you can pay off the balance anytime soon. It will also affect your credit score. However, this choice could protect your retirement savings. Just make sure to seriously consider whether you’re able to pay off the debt in a reasonable amount time and it won’t cause more financial damage than its worth.

401(k) Penalty FAQs

You have questions about 401(k) penalties. We have answers.

How much taxes will I pay if I withdraw my 401(k)?

When you withdraw funds from your 401(k), the amount you’ll pay in taxes varies based on your tax bracket. High-income earners will likely pay more taxes on their withdrawals than low-income earners.

What happens if I withdraw from my 401(k) early?

If you withdraw funds from your 401(k) before age 59.5, you’ll likely face an early withdrawal penalty. However, the tax code outlines some specific exceptions to this rule.

Can I withdraw 401(k) contributions without penalty?

If you’re over the age of 59.5, you can withdraw 401(k) contributions without a penalty. If you need to make an early withdrawal, you’ll pay a penalty unless you qualify for a specific exemption.

How do I avoid 20% tax on my 401(k) withdrawal?

You can avoid paying a 20% tax on your 401(k) withdrawal by rolling over the funds to a different account or taking out a loan from your 401(k). Consult with a tax professional to find the best solution for your situation.

The Bottom Line: Expect A Big Penalty For Withdrawing From Your 401(k)

If you’re withdrawing funds from your 401(k) early, you’ll likely face a big penalty. It’s possible to avoid the penalty if you meet specific eligibility requirements. Take the time to learn the rules before making any money moves.

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