Making a 401(k) withdrawal is simple enough, but it could wind up being more trouble than it’s worth due to taxes and early withdrawal penalties.
What is a 401(k) Withdrawal?
It is possible to withdraw money from a 401(k) before the age of 59 ½, the age at which people, whether they’re retired or not, may begin taking distributions without penalization. This is different from a 401(k) loan, which has a different set of rules and restrictions.
Main Types of Withdrawals
1. Regular Withdrawals in Retirement
Once 401(k) contributors reach the age of 59 ½, they are typically able to take lump-sum distributions or periodic distributions, without a penalty.
However, withdrawals are taxed as income, because the initial contributions were made with pre-tax money.
2. Required Minimum Distributions
At the age of 70 ½, people are required to begin taking funds from their 401(k), whether they want to or not. These withdrawals are known as required minimum distributions (RMDs). The reason for this is that 401(k) contributions are untaxed, and the government cannot gain revenue off of a 401(k) until it begins being distributed.
Just like regular withdrawals, RMDs are taxed as income. The amount of each RMD is calculated based on the recipient’s life expectancy, with the intention of distributing the entire sum of the 401(k) before the recipient passes away.
3. Hardship Withdrawals
Some 401(k) contributors may qualify to make early withdrawals in case of hardship before the age of 59 ½, for the following circumstances:
- Medical expenses incurred by the contributor, their spouse or their dependents
- Costs related to the purchase of a principal residence (mortgage payments not included)
- Educational fees for the next 12 months for the contributor, their spouse or dependents
- Costs necessary to prevent the contributor from being evicted or having their home foreclosed
- Funeral expenses
- Expenses incurred while repairing damage to the contributor’s principal residence
However, the IRS imposes a 10 percent penalty in order to discourage people from dipping into their retirement savings too early. In addition to the IRS penalty, hardship 401(k) withdrawals are also taxed.
It is only recommended that hardship withdrawals be made as a last resort in extreme circumstances. Some 401(k) plans may not allow for hardship withdrawals.
4. Penalty-Free Withdrawals
Penalty-free withdrawals before the age of 59 ½ are exempt from the 10 percent IRS penalty, but they are not tax-free. These withdrawals can only be made if the contributor:
- Has a qualified disability
- Has medical expenses up to the amount allowable as a medical expense tax deduction
- Is required by court order to give money to a divorced spouse or a dependent
- Has experienced a disaster which has been granted IRS relief
- Has left a job and has set up a schedule to withdraw periodic payments for five years or until age 59 ½, whichever is longer
Some 401(k) plans may not allow for early, penalty-free withdrawals.
While 401(k) withdrawals may seem like a tempting way to pay off short-term debt and expenses, it’s not always the best option when the potential penalties are taken into consideration. Always meet with a local Certified Financial Planner Professional™ before making a decision.