It takes times, patience, and consistency to build retirement savings. As you regularly contribute and invest for years (even decades!), you gradually build wealth intended for those golden years. But sometimes, the reality of life right now may stop you in your tracks — and the money you’ve been stashing away for the future can feel like your only option. When an early 401(k) withdrawal seems like your lifeline to make it through financial hardship, here’s what you need to know and what you might want to consider before doing so.
What are the 401(k) withdrawal rules?
- Distributions begin at age 59 ½
- Early distributions may result in a 10% tax penalty
- 401(k) loans and certain hardship withdrawals will not be penalized
Retirement accounts, like 401(k)s and Individual Retirement Accounts (IRAs), have a lot of rules surrounding why and when you can withdraw from them. It’s a good idea to understand the basic rules surrounding 401(k) withdrawals, as making early distributions can be an expensive mistake if you aren’t aware of the guidelines.
When you put money into your 401(k) account (an employee-sponsored retirement plan), it grows tax-free until retirement. Once you reach age 59 1/2, you can begin to withdraw the money without penalty. However, you’ll still be responsible for paying taxes on the amount your account has appreciated by.
Should you make a withdrawal before age 59 ½, you’ll have to pay ordinary income taxes on the money you take out, and you’ll typically incur a 10% tax penalty on the amount withdrawn as well.
Because taking money from your 401(k) can be costly (and can potentially harm your savings in the long run) it’s a good idea to consider exhausting all other options before doing so. That could include using emergency savings, tapping into other investments, or taking out a personal loan.
How to Borrow Against or Withdraw from Your 401(k)
If using funds from your retirement account makes the most sense for your financial situation, you’ll probably want to explore your options. Technically, 401(k)s offer three types of early withdrawals. First, a 401(k) loan, which allows you to withdraw from your 401(k), but you must repay the money — basically borrowing against your 401(k). Then, you also have early distributions. This kind of early withdrawal will result in the 10% penalty and is not meant to be repaid. Finally, depending on the circumstances of your withdrawal (like a medical emergency or coronavirus-related hardship), you could qualify for a hardship distribution and be exempt from the 10% early withdrawal penalty.
Let’s take a look at what each of these options entails.
- No tax penalty
- Borrow up to $50,000 or half your account balance
- Money must be replaced
Many 401(k) plans offer the option of taking out a loan from your balance. If you’re eligible, the benefit of this is that the money you withdraw from your account won’t be lost forever, as you’ll replace it over time. Plus, you won’t be hit with those expensive 10% early withdrawal penalties.
401(k) loans can be a relatively simple way to get the cash you need now, so long as you anticipate being able to pay back your loan in full within the specified time period. As long as you don’t exceed the loan limits or violate any of the loan repayment terms, a 401(k) loan can provide you the money you need, potentially cost less than taking out a loan from a bank or other lender, and cause minimal harm to your retirement savings compared to an early withdrawal.
When taking out a 401(k) loan, you can borrow up to $50,000 or half of your account balance — whichever is the lesser amount.
Typically, these loans must be repaid within five years — though there are certain exceptions to this rule, like if you use the loan to pay for your home (which must be your primary residence) or if you lose or change jobs. But the quicker you can replenish the funds, the better, so that you can get your retirement account back on track. After all, your funds miss out on any potential growth opportunities when they’re not deposited in your 401(k) account.
While 401(k) loans are not like typical loans (they don’t involve a lender), you are still charged interest. The good news? Any interest payments you make don’t go to the bank. Instead, they’re deposited back into your 401(k) account as investment income.
401(k) Loans and the CARES Act
On March 27, 2020, Congress passed the CARES Act (Coronavirus Aid, Relief, and Economic Security Act) due to the financial impact of COVID-19 on individuals, families, businesses, and more. Part of the CARES Act has provided more early access to retirement funds for those affected by the coronavirus.
While the CARES Act is in place, the loan limit for 401(k) loans has been extended to 100% of your vested balance, up to $100,000. Loan repayments may be deferred for up to one year.
401(k) Early and Hardship Withdrawals
- Depending on the reason for withdrawal, may be subject to 10% tax penalty
- Borrow only up to the amount you need
- Money is not to be replaced
If a 401(k) loan is not an option for you, you might see if your 401(k) plan allows you to make early withdrawals or hardship distributions — which means taking money out of your 401(k), before age 59 ½, that doesn’t need to be repaid.
Typically, plans allow you to take out money for needs like buying a home or for higher education-related tuition or fees. Keep in mind, while these are allowed, most early withdrawals are subject to the 10% early withdrawal penalty.
Certain reasons for withdrawing from your 401(k) may be exempt from the penalty. These are called financial hardship withdrawals.
What qualifies as financial hardship?
According to the IRS, hardship withdrawals are allowed only when there is an immediate and heavy financial need — but it is up to employers to define when hardship distributions may be allowed.
It’s important to note that not all hardship distributions are exempt from the 10% tax penalty. Examples of situations that are exempt include certain medical expenses that exceed 7.5% of your adjusted gross income and permanent disability. Visit the IRS website for more information on what is and is not subject to the early withdrawal penalty.
If your employer allows early withdrawals or hardship distributions, you can typically withdraw only the amount necessary to meet your financial need — plus enough to cover the associated taxes and fees.
Early 401(k) Withdrawals and the CARES Act
The CARES Act also has an impact on early 401(k) withdrawals. Individuals affected by COVID-19 may also withdraw up to $100,000 from 401(k) accounts without incurring the 10% penalty. This distribution can be taxed evenly as income through tax year 2022, and taxes paid within that three-year period may be refunded.
People eligible for these early distribution extensions include those diagnosed with COVID-19, as well as people who have experienced adverse financial consequences due to the pandemic. That includes job loss or furlough, work hours cut, reduced income, inability to work due to lack of childcare, or business closure.
Should I withdraw from my 401(k) to pay off debt?
In certain scenarios, using funds from your 401(k) could make sense to pay off debt — namely, if you’re paying off high-interest debt. Typically, credit cards have some of the highest interest rates (compared to other forms of debt, like a mortgage or student loan), and holding large amounts of credit card debt can become extremely expensive.
Before making an early withdrawal from your 401(k) to pay off debt, you may want to weigh the cost of your interest payments vs. the tax penalties you would face. While, depending on your debt and your interest rate, an early withdrawal could cost you less money in the long run, it’s a good idea to consult a tax professional or financial advisor before making any decisions.
Does withdrawing from your 401(k) make sense?
Before making a 401(k) withdrawal, it’s important to consider the long-term effects on your retirement account and weigh them against your immediate need. What may seem like a reasonably small withdrawal now, could result in significantly less savings growth in the future.
For example, if you have $40,000 in your 401(k) now and withdraw $2,000, you could potentially miss out on nearly $12,000 over 30 years. That’s because $40,000 in savings could reach about $230,000 if it averages a 6% annual return over 30 years. With the same annual return, $38,000 would only grow to about $218,000.
On the other hand, because of the new rules under the CARES Act, tapping into your 401(k) could help you stay afloat and avoid taking on burdensome debt during a difficult time when all other options are exhausted. Just keep in mind that although withdrawal limits have been extended for loans and hardship distributions, it’s a good idea to strictly use only as much as you need.
Most importantly, because Ally Invest does not offer tax or legal advice, make sure to consult with a tax and legal professional and/or your financial planner to make sure you understand all of the benefits and drawbacks of withdrawing money from your retirement accounts in times of need.
When times are tough, using funds from your 401(k) may feel like the best option — especially when retirement seems more like an abstract idea compared to the realities of right now. But it’s a good idea to consider any possible alternatives, from savings to loans, before tapping into your retirement account. Because the more you can avoid taking out now, the more long-term growth you’ll see down the road, when retirement becomes reality.