What You Should Know About Early 401(k) Withdrawals

Early 401(k) withdrawals may be subject to more than just income taxes

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As your 401(k) account grows in value, it can be tempting to spend your hard-earned savings. Many people find it difficult to treat their retirement savings as off limits, particularly when immediate expenses arise. But early 401(k) withdrawals can sacrifice important tax benefits of your hard-earned previous plan contributions. They can also put you on the hook for additional penalties.

Whether you need a down payment for a new house, college tuition for your kids, or cash for a financial emergency, understand the 401(k) early withdrawal penalties and proceed carefully.

401(k) Early Withdrawal Penalties

The tax benefits are among the biggest advantages of contributing to a 401(k) plan. Not only is each traditional or pretax 401(k) plan contribution tax-deductible, but it also grows tax-deferred. This means that contributions reduce your taxable income—and, hence, the amount you owe in taxes—right now. You'll also put off paying income taxes on contributions and earnings until distribution. With post-tax Roth contributions, you won't get a deduction up front, but you can make qualified distributions tax-free.

However, these tax benefits are only applicable when you abide by the rules of the plan. These rules limit everything from how much you can contribute annually to when you can withdraw funds from the plan penalty-free.

If you withdraw funds from your traditional 401(k) before you reach at least age 59 1/2, you'll owe income tax on the amount withdrawn. With rare exception, the withdrawn funds will also be subject to an additional 10% early withdrawal penalty tax. Incidentally, this penalty also applies to the early withdrawal of Roth IRA funds.

In an ideal situation, you wouldn't withdraw funds from your 401(k) until after you retire. You'd still pay income tax on those withdrawals just as you did with each paycheck you earned when you were employed. But many people find that they're in a lower tax bracket in retirement than they were during their working years, which can add up to some tax savings.

For some people, taking an early withdrawal can reduce the total amount they pocket by half after paying taxes and penalties. The tax hit can hurt your finances in the short term. Even if you qualify for penalty-free early withdrawals, they could cost you in retirement by severely restricting your income.

Exceptions to 401(k) Early Withdrawal Penalties

There are several exceptions to the 10% penalty that are intended to limit some of the financial loss in certain situations. Under the following circumstances, 401(k) withdrawals made before you reach age 59 1/2 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 have unreimbursed medical expenses exceeding 7.5% of your Adjusted Gross Income (this goes up to 10% for 2021).
  • You begin substantially equal periodic payments (see Rule 72(t)).
  • Your withdrawal is related to a Qualified Domestic Relations Order.
  • You took a qualified coronavirus-related early 401(k) withdrawal under the Coronavirus Aid, Relief, and Economic Security (CARES) Act between Jan. 1 and Dec. 30, 2020.
  • You take a qualified disaster-related early 401(k) withdrawal (not for COVID-19) under the Taxpayer Certainty and Disaster Tax Relief Act of 2020 between Jan. 1, 2020, and June 24, 2021.

Withdrawals in each of these scenarios would only be subject to ordinary income taxes and not the additional 10% penalty. But the withdrawals must be made according to plan rules and with appropriate documentation. Educate yourself about your plan's requirements before you take such a withdrawal.

Stimulus and Other 401(k) Early Withdrawal Considerations

Don't take an early distribution from your retirement plan just because you can—even if you can take one without penalties. There are other important criteria to factor in when pulling money out of an account intended for your long-term use.

Investment Growth Prospects

In addition to penalties and taxes due upon an early withdrawal, you'll lose the potential future gains of that retirement plan money. For example, there are annual limits to the amount you can contribute to a 401(k) plan, so you can’t make up for a previous withdrawal later. While catch-up contributions are permitted for savers aged 50 and over, it would be much more difficult to save enough to "catch up" on the lost earnings and compound interest.

401(k) Loans

Although 401(k) loans have their own significant drawbacks, such as the need to make payments with interest, you may want to consider such a loan if you're in a financial pinch and your only option is your retirement money. If you have the discipline to make on-time payments, a 401(k) loan may be preferable to an outright 401(k) withdrawal with penalties, although neither is ideal.

CARES Act Stimulus 401(k) Withdrawal Changes

In March 2020, President Trump signed into law the CARES Act, a $2 trillion economic stimulus package intended to soften the health and economic impacts of COVID-19. The act included several provisions that allowed for more flexible use of retirement plans such as 401(k) plans to help cover emergency expenses, some of which have since expired.

Penalty-Free Early Withdrawals

Under the CARES Act 401(k) provisions, individuals under the age of 59 1/2 could take up to $100,000 in coronavirus-related early distributions from their 401(k) plans through Dec. 30, 2020, without facing the 10% early withdrawal penalty in certain conditions:

  • You, a spouse, or a dependent were diagnosed with coronavirus.
  • Your finances were impacted adversely because you were quarantined, furlough, or laid off as a result of the virus.
  • You couldn't work because the virus prevented you from obtaining child care.
  • You owned or ran a business and the virus forced you to close or reduce operating hours.

This special allowance for early withdrawals with no penalties retroactively applies to coronavirus-related distributions made between Jan. 1 and Dec. 30, 2020. It does not apply to withdrawals made on or after Dec. 31, 2020.

Additionally, Congress passed the Taxpayer Certainty and Disaster Tax Relief Act of 2020, which extended this benefit to victims of qualified disasters other than coronavirus in 2020. Under this legislation, anyone affected by an officially declared major disaster between Jan. 1, 2020, and Feb. 25, 2021, can take qualified disaster distributions of up to $100,000 from their 401(k) through June 24, 2021, without penalty.

Spread out Your Tax Payments

You will still owe income tax on 401(k) early withdrawals under the stimulus bill, but you can pay taxes on them over a three-year period beginning in 2020.

Recontribute What You Took out of Your 401(k)

The stimulus bill allows you to re-contribute to the 401(k) plan through one or more payments made within three years. These contributions will not count toward the 401(k) annual contribution limits.

Borrow More From Your 401(k)

The stimulus bill also doubled the limit on 401(k) loans from $50,000 to $100,000, up to a maximum of 100% of the vested account balance. But you had to take out a loan from your 401(k) within six months from the time the stimulus bill was enacted (by Sept. 23, 2020). The other catch? The CARES Act merely allowed—but didn't require—plans to grant this increased borrowing limit. Always check with your 401(k) plan administrator for the loan limits that apply to you.

401(k) Required Minimum Distributions

On the other end of the spectrum, you can defer taking distributions from your 401(k) plans until April 1 of the year following the year in which you reach age 72 (or age 70 1/2 if you reached age 70 1/2 before July 1, 2019).

After that point, you generally must withdraw at least your required minimum distribution (RMD) annually. However, exceptions apply. The CARES Act, for example, waived all RMDs from 401(k) plans for 2020, including your first RMD.

Your RMD is calculated by dividing your account balance on December 31 of the previous year by a distribution period based on your life expectancy as defined by the IRS in the life expectancy table relevant to your marital status and beneficiaries. All three of the tables (Uniform Lifetime Table, Single Life Expectancy, and Joint Life Expectancy) are found in Publication 590-B.

Like an early withdrawal, failure to take 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.