Are you part of the 52.5 million Americans who participate in their employer’s 401k plan?
Have you been considering withdrawing some of the money that you’ve been saving?
Before you move forward with an early withdrawal, it’s important to understand the rules. You could face some pretty high penalties if you don’t take the time to do your own research.
Luckily, we’ve made it easy for you.
Read on for everything you need to know about early 401k withdrawal.
Types of Early 401k Withdrawal
There are a few different types of 401k withdrawal, some that come with penalties from the IRS and some that don’t.
If you’re 59 and-a-half years of age or younger when you withdraw money from your 401k, it’s considered an early withdrawal.
Unless you have a very specific reason for taking money out of your 401k, the money is considered part of your regular income, and it’ll be taxed accordingly. You’ll also have to pay a 10 percent penalty for early distribution.
Some employers allow you to take what’s known as a hardship withdrawal from your 401k, even if you are younger than 59 and-a-half.
If you qualify for this kind of 401k withdrawal, you’ll take all the money you’ve invested in your 401k. Employer contributions or earned interested usually are not touched.
There are very specific rules about what situations qualify as hardships.
The following are the most common hardships that lead people to take an early 401k withdrawal.
- Large medical expenses
- Costs related to purchasing your principal residence (mortgage payments do not count)
- A year’s worth of college tuition, fees, and/or room and board for you, your spouse, or your dependents
- Costs to prevent eviction or foreclosure
- Funeral expenses
- Some expenses related to major home repairs
In order to take out a hardship withdrawal, you first need to find out if your employer allows them. You can find this out from your human resources or personnel department.
From there, you have two options. First, you can provide financial proof to your employer that you need the money from your 401k. Second, you can “self-certify.”
When you self-certify, you don’t have to disclose your financial situation. But, you’ll have to wait six months after the withdrawal before you making any new 401k contributions.
A hardship withdrawal will still be counted and taxed as part of your annual income. You also will most likely have to pay the 10 percent penalty for early withdrawal.
There are some situations in which you can withdraw money from your 401k early without paying the 10 percent penalty. Some of these situations include:
- A qualifying disability
- Some major medical expenses
- Court order that requires you to give the money to your divorced spouse, a child, or a dependent
- A disaster that qualifies for relief by the IRS
You can also withdraw money without a penalty if you’ve left your employer and have set up a withdrawal schedule. This schedule will provide you with periodic payments for at least five years, or until you reach 59 and-a-half years of age, whichever is longer.
Penalty-withdrawals are exempt from the 10 percent IRS fee, but they are not tax-free.
As with hardship withdrawals, you’ll need to ensure that your employer allows them. Your human resources or personnel department can give you this information and help you apply for them.
Early Withdrawal Alternatives
If you want to avoid the penalties associated with early withdrawal, you still have options. Some alternatives to early 401k withdrawal include:
Keep Your Finances in Order
The easiest way to avoid early 401k withdrawal is to avoid spending money that you don’t have. Track your spending carefully and plan for expenses like insurance, home and vehicle repairs, and medical costs.
It’s also important to have a sufficient emergency fund. This will help you avoid situations where you need to tap into your retirement funds.
Try to deposit money every month into a savings account. Even if you can only afford a couple hundred dollars a month, it’s still better than not having anything put aside.
You can also set up a home equity line of credit. This will allow you to use the equity you’ve accrued in your home as an emergency fund if an unexpected expense arises.
Some 401k plans will allow you to borrow a portion of the money you’ve paid into them.
When you borrow money this way, the amount is not taxable unless you do not pay off your balance. You can also make payments back into your own account to replenish what was borrowed.
401k loans are only allowed for current employees.
Many financial advisers advise against loans for people who are struggling to keep up with their current payments. The loan may provide temporary relief, but it will ultimately just be one more payment that the borrower needs to stay on top of.
If you have a 401(k) plan with an employer you are longer working for, one option is to roll that account over to an individual retirement account (IRA).
In some situations, including those listed below, you can withdraw money penalty-free from an IRA:
- Non-reimbursed medical expenses
- First-time home purchase
- Medical insurance premiums
- Some higher education expenses
This option is more sometimes advised for people who have recently lost their job and need to make one of the payments listed above.
There are a few conditions, though.
Before you proceed with an IRA withdrawal instead of a 401k withdrawal, you will need to have received unemployment compensation for at least 12 weeks. The withdrawal will also need to be made in the year of or the year immediately after unemployment.
Roth IRA Withdrawals
Another option is to withdraw from the contributions you’ve made to a Roth IRA.
Your Roth IRA contributions are made with money that has already been taxed. This means that you can withdraw your money without paying additional taxes.
The exceptions to penalties for withdrawing money early from your Roth IRA are the same as for an early IRA withdrawal (higher education expenses, disability, medical expenses, etc.)
Series of Substantially Equal Period Payments
If you’re in a jam and really need cash, you may also consider taking money out of your IRA in a Series of Substantially Equal Periodic Payments (SOSEPP).
When you do this, the IRS determines the amount that you receive each year. They base this amount on your life expectancy and the balance in your account the year prior to your withdrawal.
Once this amount has been determined, you must withdraw it every year.
There are a few risks that come with these payments. The biggest is the fact that you cannot stop the withdrawals until five years has passed or you’ve reached 59 and-a-half years of age, whichever is longer.
Basically, this means that you can’t change your mind.
When you stop the withdrawals, you are hit with the 10 percent penalty for early withdrawal. That penalty is also applied retroactively, and with interest, from the time you first started to receive the payments.
Depending on your situation, there may be better alternatives to early 401k withdrawal or IRA withdrawal.
If you’re experiencing extreme financial hardships, instead of taking money from your retirement accounts, you may want to seek bankruptcy protection.
Federal law states that assets that are part of a retirement plan or IRA are excluded from creditors’ judgments during bankruptcy.
If you think bankruptcy is inevitable, it would be better to begin the process and avoid prolonging it temporarily with your retirement funds.
That way, once the process is complete, you’ll still have the money in those accounts. Many states also provide exemptions for your home, so you’ll still have some assets afterward.
Talk to a Professional
Before you move forward with an IRA, Roth IRA, or 401k withdrawal, make sure you talk to a professional.
A CPA or financial adviser can provide you with potential alternatives to an early withdrawal. He or she can also help you avoid complicating future situations.
For example, low-income individuals with large, uninsured medical expenses can sometimes qualify for certain kinds of Medicaid benefits.
If you make a 401k withdrawal without consulting anyone, you can complicate the application process. You may also disqualify yourself from benefits that could have helped you avoid the early withdrawal in the first place.
Bottom line: don’t touch your 401k or any of your other retirement accounts without first speaking to a professional. You also shouldn’t make any decisions about filing for bankruptcy without first speaking to a qualified attorney.
Want to Learn More?
Now that you’re filled in on early 401k withdrawal, you can make the decision that makes the most sense for your specific financial situation.
If you’re considering withdrawing money from your 401k before retirement, be sure to consider some of the alternatives we’ve discussed here. And, don’t forget to talk to an accountant or financial advisor before making any final decisions.
Want to learn more about managing your finances? Whether you’re interested in retirement accounts, investments, credit, or home financing, we can help.
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