What You Need to Know About 401(k) Early Withdrawals

Early 401(k) Withdrawals can be Subject to More Than Just Income Taxes

Cash in a jar marked 401k
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As you follow sound retirement planning advice and begin or continue to consistently contribute to an employer-sponsored retirement plan like a 401(k), it can be tempting to watch that account value increase and see all of the more immediate benefits of that money. Most people find it difficult to view their retirement savings as off-limits, particularly as more immediate needs and wants arise. But whether it's the need for a down payment on a new house, college tuition for your kids, or even an unexpected financial emergency, when considering a 401(k) withdrawal it is important that you proceed very carefully.

Every 401(k) withdrawal means sacrificing important benefits of your hard earned previous 401(k) plan contribution and may even lead to higher income taxes and additional penalties.

401(k) Account Withdrawal Rules and Penalties

One of the most helpful benefits of employer-sponsored retirement plans like a 401(k) plan is that each contribution is rewarded with tax benefits. This means that not only is your contribution tax deductible today, but you also get the benefit knowing that the investment growth of your account is also growing tax-deferred. But these tax benefits are only applicable when you abide by the rules of the plan, which limit everything from the amount of you can put in the plan annually and when you can withdraw funds from the plan penalty-free.

With rare exceptions, all traditional 401(k) withdrawals are taxable as ordinary income (Roth 401k assets are treated differently).

In an ideal situation, you will not withdraw funds from your 401(k) until after you retire and as you did when you were employed, you will pay income taxes on those withdrawals just as you did with each paycheck. Many find that they are also in a lower tax bracket in retirement than they were during their working years, which can add up to some relative tax savings even when paying income taxes in retirement.

But if you were to withdraw funds from your 401(k) before you reach at least age 59½, however, you will not only owe income taxes on the amount you withdrew, those funds would also be subject to an additional 10% early distribution penalty tax. This is where things get sticky fast. For some people, this can mean cutting the total you withdrew almost in half after paying taxes and penalties! Not only does "losing" that money to taxes today hurt, because of the opportunity cost, it will cost your retired self even more.

Exceptions to 401(k) Withdrawal Penalties

That said, there are several exceptions to the 10% early distribution penalty that are meant to alleviate some of the financial loss in certain situations. 401(k) withdrawals made before you reach age 59 ½ under the following circumstances are exempt from the additional penalty:

  • You die and the account is paid to your beneficiary
  • You become disabled
  • You terminate employment and are at least 55 years old
  • You withdraw an amount less than is allowable as a medical expense deduction

Withdrawals in each of these scenarios would only be subject to ordinary income taxes, not the additional 10% penalty, but the withdrawals must be made according to plan rules and with appropriate documentation, so be sure to educate yourself about the plan requirements before opting for such a withdrawal.

Additional 401(k) Early Withdrawal Considerations

In addition to penalties and taxes due upon a 401(k) early withdrawal, we cannot overlook the loss of all of the potential future investment growth of that retirement plan money. Furthermore, since there are annual limits to the amount you can contribute to a 401K plan, you can’t make up for a previous withdrawal later. Not to mention, it would be much more difficult to save enough to "catch up" on the lost earnings and compound interest.

Although 401(k) loans have their own significant drawbacks, you may want to consider a 401(k) loan if you are in a financial pinch and your only option appears to be your retirement money. Even with its drawbacks, a 401(k) loan is generally preferable to an outright 401K withdrawal, though neither are ideal.

Delaying Your 401(k) Withdrawals and RMDs

On the other end of the spectrum, most people may delay receiving distributions from your 401(k) plan and thereby maximize the benefits of your tax-deferred growth until April 1 of the year following the year in which you reach 70½. Subsequently, you must withdraw at least your Required Minimum Distribution (RMD) annually.

Your RMD is calculated as your account balance as of the beginning of the year in question divided by your life expectancy as determined by the IRS in its Uniform Life Expectancy table (unless your sole beneficiary is your spouse and your spouse is more than ten years younger than you). Like an early withdrawal, however, not taking your annual RMD comes with a steep penalty. The penalty for not withdrawing your RMD is 50% of the difference between what should have been distributed and what was actually withdrawn.

Updated by Scott Spann

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