During challenging financial times, people often consider withdrawing money from their 401(k) plans. Balances in 401(k) plans are deceiving. They are not like checking accounts where what you see is what you can withdraw. If you have not been saving in the Roth portion of a 401(k) plan, the money has not yet been taxed. Roth 401(k) accounts are subject to a 5-year holding rule.
For most people, withdrawing from a 401(k) before age 59½ triggers early withdrawal penalties.
But there are times when it makes financial sense to tap into these retirement savings early. This article will walk you through key exceptions, smart strategies, and important IRS guidelines so you can make informed choices—without giving Uncle Sam more than you need to.
The Earliest You Should Take Funds Out, Ideally
Congress determined that the early retirement age was 59 ½. The associated tax breaks for 401(k) plans are due to the fact that the money is intended for your retirement. In order to disincentivize uses of the money prior to retirement they attached a penalty. Normally, if you take money out of a 401(k) before turning 59½, you’ll owe:
- Income tax, both Federal and State, on the full amount, plus
- A 10% early withdrawal penalty
In fact, the withdrawal will be taxed at your marginal income tax rate. The withdrawal could potentially push you into a higher marginal bracket.
Good Reasons For Withdrawing Money Earlier
If you’re a Baby Boomer facing a layoff, a Gen Xer managing a crisis, or a Millennial weighing a career pivot, knowing the rules can help you avoid costly mistakes.
With all your best intentions, you may have racked up some credit card debt, lost your job, ran through your emergency reserves, etc. You may be able to qualify under a hardship situation.
Bad Reasons For Withdrawing Money Earlier
Buying a car or something that does not appreciate. In that case, you are better off to simply pay payroll taxes like you do for the majority of your money. That way you avoid the 10% penalty. Matching contributions may complicate that situation, but that is beyond the scope of this article.
I heard someone talking about seeing her parents balance fluctuate in the market. She recommended to them that they simply withdraw their money. There has always been and will always be fluctuations in the US and Global markets. Risk itself is part of how we are rewarded as investors. Instead, you may look at your asset allocation and see if one with less volatility will still help you retire. Only a small number of my prospects or clients ever showed me a financial plan for their retirement. Of that small number, none of them understood the assumptions that determined the conclusion. I recommend finding a Certified Financial Planner to help you have a retirement plan and then an investment strategy that does not have you making a fear-based withdrawal. Does your hardship definition meet the hardship definition of the IRS?
Hardship Withdrawal
Hardship Distribution
Your 401(k) plan might allow hardship withdrawals for certain qualifying financial needs, such as:
- Medical expenses
- Costs related to purchasing a primary residence
- Tuition and education expenses
- Payments to prevent eviction or foreclosure
- Funeral expenses
- Certain home repair expenses
Other Circumstances:
- Disability: Early withdrawals are permitted if you become totally and permanently disabled.
- Death: Distributions to beneficiaries after the account owner’s death are allowed.
- Unreimbursed Medical Expenses: Withdrawals are permitted if they exceed 7.5% of your adjusted gross income (AGI).
- Qualified Reservist Distributions: Withdrawals are allowed for military reservists called to active duty.
- Qualified Domestic Relations Order (QDRO): Dividing retirement assets during a divorce is allowed.
This list is not intended to be comprehensive. It is to be instructive. It is important to reach out to your Human Resources Benefits personnel to learn more about your plan’s options. Some employers may be in a situation to modify plan rules to accommodate. A more complete list of hardship withdrawals that avoid the 10% early withdrawals can be found here on the IRS website.
All of these withdrawals are still subject to income taxes and might have plan-specific restrictions. Often people are let down when they find out how much their balance may be reduced. When specifying a withdrawal, Payroll will withhold some percentage of the requested withdrawal for taxes. To avoid that circumstance, request a net distribution where the payroll company will take the taxes from account before the distribution is made.
Potentially Valid Reasons For Withdrawing Money Early
With all your best intentions, you may have lost your job, ran through your emergency reserves, etc. You may be able to qualify under a hardship situation. That only means that you avoid the 10% penalty, not taxes. The IRS mandates 20% tax withholding.
In the future, if you were to save for an emergency into a simple savings account, you would be doing so with money that your employer had already taken out taxes. This account would not have you facing a potential 10% early withdrawal penalty.
Risks And Negative Impacts Of Withdrawing Money Early
The real risk is not being able to replace the money that you have withdrawn and its impact. For example, your money cannot compound if it is not invested. You typically will then have to save more to make up for lost time. The longer it takes you to replace the money, the harder your money will have to work. That means either saving more money, taking on more market risk, or potentially lengthening the time you will have to work to achieve the same lifestyle the original contribution would have allowed you to live.
Instead of working hard, you may decide to live on less. You will need to revive your financial retirement plan to see what you feel is doable. You can gather insights in my article, Retirement Planning: Income Replacement Or Lifestyle Spending Method? All of these calculations can be done by financial planning designated adviser such as a Certified Financial Planner, Chartered Retirement Counselor, etc.
Better Alternatives To Removing Money Early
401(k) Plan Loan
Likely you are reading this article because of tough times. Instead of a withdrawal, assuming you remain employed, you may be able to take a loan if your plan allows for it. A loan actually increases the potential amount of money you may be able to access compared to a penalty and taxable withdrawal. You will be able to access the lesser of half of your current balance or $50,000. In that case, there are no taxes or penalties. This allows you to keep more of your money in the plan, hopefully allowing it to grow. You will have to make loan payments. If you fail to make those payments, your loan will be deemed a distribution, and you will face the previously mentioned taxes and penalties. The IRS provides more detail on 401(k) plan loans here.
Roth IRA Contributions
Do you have a Roth IRA? You can withdraw Roth IRA contributions (but not earnings) at any time, for any reason, without tax or penalty (assuming you are above age 59½). That makes it a useful emergency backup—if you’ve been contributing. If you have a Roth inside of your plan, it is not a Roth IRA. It technically is a Designated Roth Account. Reach out to Human Resources Personnel to see what options you have for tapping into as it has some peculiarities compared to the Roth IRA.
Systematic Savings
If you are in a position to wait, consider a systematic savings plan. This could include temporarily stopping contributions to the plan. In this case, you will avoid the 10% that will come from the 401(k) withdrawal.
Best Practices For 401(k) Withdrawals
If you’ve decided withdrawing early is the right move, consider:
- Document your exception – The IRS may ask for proof.
- Calculate tax impact – A CPA or tax software can help.
- Consider partial withdrawals – Take only what you need.
- Browse the 401(k) provider website – Often the 401(k) providers website has instructions for you to check out. Minimally there will be some paperwork for you to fill out. Reach Human Resources Personnel for guidance and or your designated financial planner.
Often the plan has designated a tax rate to be withheld. Depending on your income, that may be high or low. If it is too low, consider having it increased when completing the distribution paperwork, or have the money available by April 15 to make up for the difference. You may have deductions or changes in income where the standard withholding is appropriate.
Closing Thoughts
Early 401(k) withdrawals aren’t always a mistake—but they should be done carefully and with the right advice. The 10% penalty exists for a reason: to protect your retirement future. But with the right strategy and knowledge, you can make choices that work for your life now and later.
Before you withdraw, ask:
- Am I using one of the IRS-approved exceptions?
- Can I afford the tax and penalty hit?
- Have I considered other options, such as a plan loan?
- What adjustments will I need to make for my long-term retirement income?
As I noted in my Roth Conversions article, tax planning plays a huge role in preserving retirement savings. Early withdrawals reduce your future compounding growth—so the impact grows over time.
Professional advice from a designated financial professional such as Certified Financial Planner™ or CPA may save you hundreds of thousands down the road. Their short-term cost could easily provide a significant return on investment.
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