Retirement Accounts • March 21st, 2020

How to make a 401(k) withdrawal and avoid penalties

Michael Schultheiss

Key Takeaways
  • Taking an early withdrawal from your 401(k) plan should be considered a last resort.
  • The IRS will typically charge a 10% fee for early withdrawals, on top of regular income tax.
  • Under certain circumstances, you can make an early withdrawal without paying the fee.

Your 401(k) is the backbone of your retirement. That’s why it should be tapped only as a last resort. But what happens if you need to make a 401(k) withdrawal early?

Ordinarily, the IRS will fine you a tax penalty of 10%. However, there are some circumstances under which you are allowed to take an early withdrawal completely penalty-free.

How 401(k) Plans Work

All 401(k) plans are tax-advantaged retirement accounts that are provided by employers. The name 401(k) refers to the appropriate section of the U.S. Internal Revenue Code.

If you have a 401(k), you are contributing to it by having your employer withhold part of your paycheck. This is called automatic payroll withholding, meaning that the money is automatically taken out of your check and put into your 401(k) account. Your employer can also contribute to your 401(k) account, matching at least some percentage of what you are putting in. The money in a 401(k) account is then invested in a variety of different things. Stock and bond mutual funds and target date funds are common investments for 401(k)s.

Because 401(k)s are provided by employers, it is their responsibility to set up the program. Employees have to choose whether to participate and how much they want to contribute. They also have to decide where to invest their 401(k)s, from the options offered by their employers. Unlike a pension, the investment risk falls on the employee rather than the employer.

Traditional 401(k)s vs. Roth 401(k)s

If you have a traditional 401(k), all of your earnings will be tax-deferred until you withdraw them. Pulling money out of your 401(k) will mean you will have to pay taxes on it. Because it’ll count as income you earned this year, you may also be pushed into a higher income tax bracket.

Traditional 401(k)s are the original type of 401(k), but in 1997 Congress passed legislation creating the Roth 401(k). If you have a Roth 401(k), the money you and your employer contribute is already taxed, meaning withdrawals will be tax-free in retirement. You can withdraw your contributions at any time, since you’ve already paid taxes on them.

Depending on what your employer offers, you can have a traditional 401(k), a Roth 401(k), or both.

Penalties on Early 401(k) Withdrawals

Cashing out a 401(k) early, before you are 59 and ½ years of age, will lead to a 401(k) early withdrawal penalty. The IRS will charge you 10% of whatever you take out, unless you qualify for an exception.

The government does this to encourage people to save up for their own retirements. That said, it can still be galling if you really need the money now. It is still a good idea to examine your options and see if there is another way to get money that is more affordable and does not impact your retirement – a Certified Financial Planner can help walk through all of your options.

If you are wondering how to take money out of your 401(k) without paying the notorious 401(k) tax penalty, you’re not alone. Many people find themselves in situations where they need to make a 401(k) early withdrawal.

If you really need it, there are some qualified exceptions to the 401(k) early withdrawal penalty. If you are covered by one of these exceptions, cashing out your 401(k) early is permissible, and you will not pay the 10% penalty.

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How to Make 401(k) Withdrawals Without Penalties

You can make a 401(k) withdrawal without penalty if you qualify for an exception. Fortunately, there are several different exceptions covering a variety of circumstances. You can also take your contributions out of a Roth 401(k) at any time without penalty. The question of how to get money out of your 401(k) will depend in large measure on what your situation is.

The Rule of 55

If you retire, quit your job, or are fired in the calendar year in which you turn 55, you may take a 401(k) early withdrawal without penalty. This is called the Rule of 55.

Note that pulling money out of your traditional 401(k) will still require you to pay taxes, same as in retirement. However, you will not be subject to the 10% 401(k) early withdrawal tax penalty. Another thing to be aware of is that the IRS Rule of 55 does not apply to any 401(k)s you may have with previous employers from the years before you turned 55.

In other words, if you quit your job when you are 55, the Rule of 55 will apply to any 401(k)s you have with that employer. If you have money in one or more 401(k)s from other past employers, you will not be able to withdraw it without paying the 10% 401(k) tax penalty. However, there is a way to get around this by rolling your older 401(k)s into your current 401(k) before quitting your job. If you do that, you can use the Rule of 55 for all of your retirement savings.

Substantially Equal Periodic Payments

Let’s say you don’t want – or can’t afford – to wait until you’re 55. You want to retire before that. Under those circumstances, you can still cash out your 401(k) early and without penalty by taking substantially equal periodic payments. What this means is that you’ll take yearly withdrawals for at least 5 years, or until you reach the age of 59 and ½, whichever is longer.

If you wait until you are at least 55 and opt to do this instead of using the Rule of 55, there is a catch: you will need to keep taking substantially equal periodic payments for at least 5 years, rather than having access to all funds at the age of 59 ½.

401(k) hardship withdrawals

In some cases, you may need to withdraw early because of financial hardship. Fortunately, there are a variety of options here, depending on your plan.

One thing to note up front is that not all 401(k) plans allow for hardship withdrawals. Among those that do, not all of them cover all of the circumstances listed above.

Hardship withdrawals are all subject to an important limitation: you can only withdraw from the principal balance you have contributed. This means that you cannot withdraw funds from interest or gains that have accrued to your account.

Until recently, if you took a hardship withdrawal, the IRS prohibited contributions to your 401(k) for 6 months. However, this requirement has been lifted as of this year.

Required minimum 401(k) distributions

In many cases, you may be wondering how to get money out of your 401(k) without incurring penalties. However, waiting too long can also saddle you with penalties.

The government doesn’t want you to take out your retirement too soon, but they also don’t want you to wait too long. After all, the funds in your account are allowed to grow in a tax-advantaged fashion. Accordingly, you will need to start taking required minimum distributions (RMDs) on the year after you turn 70 and ½ years of age.

To simplify this a bit, let us say you turn 70 and ½ (your 70th birthday plus 6 months) at any point in the calendar year 2020. If you have not already started taking money out of your 401(k), your first RMD will be due by April 1, 2021.

You will want to be sure to calculate your RMD in advance. If you do not take out your full RMD by the required time, you will face a 50% penalty on whatever amount you failed to take out. It’s a good idea to talk to a certified financial planner to make sure you have the correct amount calculated for your RMD.

Bottom Line

There are some very good reasons you may want to – or need to – withdraw money from your 401(k) early.

It’s a good idea to talk to a Certified Financial Planner (CFP) before deciding to take an early withdrawal. They may be able to help you find alternative assets to tap into, or another plan to preserve your retirement savings. If you do opt for an early withdrawal, you will want to make sure you actually qualify for an exception and that you avoid any penalties.

To make the most of your 401(k) and enjoy your best retirement outcomes, talk to a Certified Financial Planner today.

Author

Michael Schultheiss

Michael Schultheiss is a freelance copywriter of long-form content and other marketing communications (B2B and B2C) in the financial services and FinTech niches. In copywriting, he looks for hungry crowds. Other interests include health, fitness, and reading and writing fiction.