The IRS has rules for when you may take distributions from a 401(k) plan or an IRA. It also has rules for when you must do so. You can face tax penalties of 10% to 50% if you don't follow these rules. They can depend on the type of account you want to withdraw from.
What Are Qualified Distributions?
Qualified distributions are those that can be taken made tax-free and penalty-free. They're taken after age 59 1/2 or under some other allowed circumstances.
There's no penalty for withdrawing your money after you reach age 59 1/2, but you'll pay income tax on the money you take out if you've invested in a traditional pre-tax 401(k) or a traditional IRA with untaxed dollars. You took a tax deduction at the time you made the contributions.
Roth IRAs and Roth 401(k) contributions are made with after-tax dollars. These distributions aren't taxed when you take withdrawals, but you must have owned the Roth account for five years or longer.
It's best to begin taking money from tax-deferred accounts—those for which you claimed tax deductions—after you retire. You might be in a lower tax bracket at that time, because you'll no longer be earning income from working.
Early 401(k) Withdrawal Rules
Early withdrawals are those that are taken from a 401(k) before you reach age 59 1/2. They're taxed as ordinary income. They're also subject to an extra 10% penalty, but there are some exemptions to this rule. You can take the money penalty-free if you're totally and permanently disabled, if you lose your job when you're at least age 55, or under the terms of a qualified domestic relations order (QDRO) after a divorce.
You can also use 401(k) money to pay for medical expenses that exceed 7.5% of your modified adjusted gross income (MAGI), as long as your insurer doesn't cover them. In other words, they came out of your own pocket.
Not only will you lose a good chunk of your savings to taxes when you make an early withdrawal, but you'll also miss out on the growth that would have been made on the withdrawn amount.
Some 401(k) plans allow for hardship distributions, but these often must be approved by your employer. They have to be made for purposes of meeting a significant, immediate need. They also can be no more than the amount necessary to meet that need.
Borrowing From a 401(k)
A 401(k) loan can be a better option than an early distribution if your employer allows it. There's no credit check with this type of loan. Interest rates tend to be lower than with other types of loans as well, but fees can apply. You must pay yourself back with interest, and you must do so within five years—or almost right away if you leave your job.
You'll lose one of the main benefits of the 401(k) if you take a loan, because you must pay yourself back with after-tax money. You'll also miss out on what could be crucial months or years of earnings on that money.
Another major downside is that you might have to pay the loan back within 90 days if you leave your job for any reason. Your loan balance would be treated as taxable income in that year if you don't. That could push you into a higher tax bracket, and you might be hit with that 10% early-withdrawal penalty as well.
Early IRA Withdrawal Rules
Early withdrawals from traditional IRAs are also subject to income taxes and the 10% penalty. They have many of the same exceptions to the penalty as 401(k)s, but there are a few differences.
You can withdraw early if you use the money to pay for certain higher education expenses, health insurance premiums that you have to pay while you're not employed, or a first-time home purchase.
IRAs don't require a QDRO to divide the account after a divorce, but they're subject to certain rules all the same.
Roth 401(k) and Roth IRA Withdrawal Rules
Roth accounts are funded with after-tax dollars, so taking money from them isn't treated the same as taking it from regular IRAs and 401(k)s. Distributions are tax-free, provided that you're at least age 59 1/2, and you've held the Roth account for at least five years. The age rule doesn't apply if the account owner is disabled or dies.
There's still a 10% tax penalty for taking money early, but that's only on earnings. You can withdraw the amount of your original contributions tax-free before age 59 1/2, because you've already paid tax on that money.
Required Minimum Distributions
You must begin taking required minimum distributions (RMDs) from your traditional IRA account when you reach age 72. The IRS will penalize you 50% of the amount you should have taken out if you don't.
The must-start age for RMDs was 70 1/2 prior to the passage of the SECURE Act of 2019, and it still is for those who reached age 70 1/2 before January 1, 2020. As of that date, the age is 72 for all others.
The IRS uses life expectancy tables to determine how much you must take out each year to avoid this 50% hit. But your 401(k) can remain intact as long as you're still working, and Roth IRA owners don't have to take RMDs at any time.
NOTE: The Balance doesn't provide tax or investment services or advice. This information is presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor. It might not be right for all investors. Investing involves risk, including the loss of principal.