Typically you need to keep the money in the plan until you reach age 59 ½. Withdraw any of it before then and you'll be hit with a bruising 10% early withdrawal penalty, on top of the regular income tax that is due on withdrawals from all traditional defined contribution plans. Bad idea.
There are exceptions, however. The IRS waives the 10% penalty for certain "hardship" withdrawals. Each plan's rules vary (check yours to be sure), but you may be able take money out of your retirement account penalty-free before age 59 ½ if you use it for expenses after the onset of a sudden disability, or for unreimbursed medical expenses that are more than 7.5% of your adjusted gross income (10% if you’re under age 65).
Don't count on it, though. This money is locked up until retirement for a very good reason: If you spend it now, you risk jeopardizing your financial security when you're older.
If you can't get the money anywhere else, your best option is probably a loan. Many defined contribution plans allow you to borrow against the amount in your account. You must repay the money to your account within a set period - usually a few years - or the loan is treated as a withdrawal, meaning you'll owe taxes and a 10% penalty on it.
There are three main drawbacks to taking out a loan. First, you reduce the money you have growing for your retirement years. Second, you have to pay interest on the amount you borrow - typically the prime rate plus one percentage point - though you do pay the interest to yourself. Third, you must repay any outstanding loan within a few months if you are laid off or decide to change jobs.
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- An Early Withdrawal From Your 401(k): Understanding the Consequences
Updated for Tax Year 2022 • September 10, 2022 01:09 PM
OVERVIEW
Cashing out or taking a loan on your 401(k) are two viable options if you're in need of funds. But, before you do so, here's a few things to know about the possible impacts on your taxes of an early withdrawal from your 401(k).
For information on the third coronavirus relief package, please visit our “American Rescue Plan: What Does it Mean for You and a Third Stimulus Check” blog post.
Tapping your 401(k) early
If you need money but are trying to avoid high-interest credit cards or loans, an early withdrawal from your 401(k) plan is a possibility. However, before you consider this option, be forewarned that there are often tax consequences for doing so.
If you understand the impact it will have on your finances and would like to continue with an early withdrawal, there are two ways to go about it — cashing out or taking a loan. But how do you know which is right for you? And what are the tax consequences you should be expecting?
A 401(k) loan or an early withdrawal?
Retirement accounts, including 401(k) plans, are designed to help people save for retirement. As such, the tax code incentivizes saving by offering tax benefits for contributions and usually penalizing those who withdraw money before the age of 59½.
However, if you really need to access the money, you can often do so with a loan or an early withdrawal from your 401(k) — just remain mindful of the tax implications for doing so.
What is a 401(k) loan?
Most 401(k) plans allow participants to borrow their own money from the plan and repay the loan through automatic payroll deductions.
Unlike personal loans and home equity loans, 401(k) loans are usually easy to get. There's no credit check, and applications are typically short. However, they're like other types of debt in that you must pay interest on the amount you borrow. Your plan's administrator determines the interest rate, but it must be similar to the rate you'd receive when borrowing money from a bank. The good news though is that you are paying interest to your own 401(k) account.
Typically, 401(k) loans must be repaid within five years. That repayment period can be extended if you use the loan to purchase a home.
What is a 401(k) early withdrawal?
Generally, anyone can make an early withdrawal from 401(k) plans at any time and for any reason. However, these distributions typically count as taxable income. If you're under the age of 59½, you typically have to pay a 10% penalty on the amount withdrawn. The IRS does allow some exceptions to the penalty, including:
- Total and permanent disability.
- Unreimbursed medical expenses (greater than 7.5% of adjusted gross income).
- Employee separated from service at age 55 or older (age 50 for most public safety employees) but only from the plan at the job you are leaving.
Some 401(k) plans allow participants to take hardship distributions while you are still participating in the plan. Each plan sets its own criteria for what constitutes a hardship, but they usually include things like:
- Medical or funeral expenses
- Avoiding eviction or foreclosure
- The cost of repairing damage to the employee's home
Hardship withdrawals don't qualify for an exception to the 10% early withdrawal penalty unless the employee is age 59½ or older or qualifies for one of the exceptions listed above.
Which is right for you?
For many, 401(k) loans are a better option than early withdrawals. After all, as long as you pay the money back during the required time period, you won't have to pay taxes on the amount withdrawn. Plus, the interest you'll pay is added to your own retirement account balance.
However, there are several reasons to think twice before taking out a 401(k) loan.
- Decreased paycheck. Most 401(k) plans require participants to repay their loan through payroll deductions. When you borrow from your 401(k), your monthly take-home pay will be reduced by the loan amount. If you're already having financial problems, a reduction in your take-home pay could exacerbate your troubles.
- Missed retirement contributions and employer matching. Some plans don't allow participants to make 401(k) contributions while they have a loan outstanding. If it takes you five years to repay your loan, that could mean five years without saving for retirement. Plus, if your employer matches your contributions, you'll miss out on matching contributions as well.
- Missed investment returns. While your money is loaned out, it's not invested in the market. You could potentially earn a better rate of return if it was invested in your 401(k) plan.
- Fees. Many plans charge origination fees and/or quarterly maintenance fees on loans. This can drastically increase the cost of borrowing money from your 401(k).
- Potential tax consequences. If you leave your job while you have a 401(k) loan outstanding, you have a limited amount of time to repay the loan. You have until the due date for filing your tax return (including extensions) to repay the loan or roll it over into another eligible retirement account.
For example, if you left your job in December of 2022 and had a $2,000 outstanding balance on your loan, you would have until April 18, 2023 (or get an extension for your tax return) to repay $2,000 in full.
- If you're not able to repay the loan, your employer will treat the unpaid balance as a distribution.
- Typically, it will be considered taxable income and subject to the 10% early withdrawal penalty.
Ideally, you want to leave your 401(k) alone until retirement. However, if you find yourself in a really tough spot, borrowing from your 401(k) might be a better option than simply cashing out your balance. Just make sure you understand the potential consequences and do what you can to repay the balance quickly so you can start rebuilding your retirement nest egg.
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The above article is intended to provide generalized financial information designed to educate a broad segment of the public; it does not give personalized tax, investment, legal, or other business and professional advice. Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law, or any other business and professional matters that affect you and/or your business.