Money saved in a 401k plan has multiple benefits, often growing unnoticed through pre-tax payroll deductions and employer matches.
It can be a comfort to see just how much you save in a 401k year-to-year, but those savings can also be a temptation when unexpected issues leave you in serious financial binds.
Facing an economic or health crisis, you might be tempted to take money out of your 401k early or even close the account, especially if you’ve amassed a healthy balance.
Just know that financial planners typically offer one word of advice: “Don’t!”
The penalties for early withdrawal almost always far exceed any benefit you may think you gain.
“Borrowing from a 401k can be a tempting option because it provides access to funds quickly and without a credit check,” Andrew Latham, a certified financial planner, and Managing Editor at SuperMoney.com, said. “However, borrowing from your 401k should be considered carefully due to the potential impact on your long-term retirement savings.”
When the federal government temporarily removed penalties for early withdrawal during Covid-19, even then taking money out of a 401k had major downsides.
A 401k account is a vital part of your future. It’s your pot of gold at the end of the rainbow (retirement). There are two good reasons not to toy with it even during a national crisis:
- The value ofstocks and mutual fundstypically plummet during a crisis. Your investment might already have lost significant value during a market downturn, meaning you already have significantly less money to borrow from.
- Less money in the account means you definitely will lose out on the gains from compounding interest that make long-term investing so attractive.
Can I Withdraw From My 401k Early?
If the alternatives to making an early withdrawal aren’t available to you – personal loans, home equity loans, using funds from a Roth IRA – it’s possible to dip into your 401k if you meet certain requirements.
You should first consult with a financial planner and your plan provider to understand the rules and ramifications of an early 401k withdrawal:
- The IRS levies a 10% penalty on all non-exempt withdrawals before the age of 59 ½.
- Since pre-taxed money funded your 401k account, your withdrawal is taxed.
- The money you withdraw stops working for you.
Latham uses the example of a 35-year-old who takes $5,000 from a 401k to deal with an unexpected financial burden.
“The true cost isn’t just the $5,000,” he said. “It’s the lost opportunity for that money to grow over time. Assuming an average annual return of 7%, by the time you reach 60, that $5,000 could have grown to approximately $27,140.”
401k Withdrawal Rules
The general rules governing a 401k allow you to make penalty-free withdrawals from retirement accounts only after reaching the age of 59 ½. Beyond that, an IRS rule mandates required minimum distributions (RMD) that begin after the age of 73.
If you take money out of your 401k early, the IRS requires a minimum withholding of 20%. In addition, it levies a 10% early withdrawal penalty.
If that seems prohibitive, it’s because it is prohibitive.
In certain situations, however, an individual might be able to withdraw funds from a 401k account early without penalty:
- You leave your job in the year you turn 55 or after (50 for certain federal job designations)
- You become disabled
- A divorce ruling mandates splitting a 401k
- The birth of a child or the adoption of a child
- The money paid an IRS levy
- You are a military reservist called to active duty
- You over-contributed to a 401k account
- You were the victim of a disaster for which the IRS granted relief
- You rolled the account over to another retirement plan
Stuff happens in people’s lives, sometimes serious stuff that leaves them with few good financial options.
It’s always a good idea to check with a financial planner and the 401k plan provider to understand available options, including hardship distributions.
Just know that while you might have an early withdrawal penalty waived under certain circ*mstances, that money you take out is subject to taxation.
Hardship Distributions from 401k Plan
If you are younger than 59 ½, you need to demonstrate that you have an approved financial hardship to get money from your 401k account without penalty. And that’s only if your employer’s retirement plan allows it. The plan provider is not required to offer hardship distributions, so the first step is to ask the Human Resources department if this is even possible.
If it is, the employer can choose which of the following IRS approved categories it allows for hardship distribution:
- Certain medical expenses
- Costs relating to purchase of a principal residence
- Tuition and related education expenses
- Payments necessary to prevent eviction from or foreclosure on a principal residence
- Funeral expenses
- Certain expenses for repairs to a principal residence
The only other way to get access to your funds is to leave your employer.
Disadvantages of Closing Your 401k
The IRS allows individuals to cash out their 401k and roll it over to an IRA without penalty and without the cashed-out amount being subject to taxation.
You can also close out a 401k without penalty when you leave your job if you are at least 55 years old, but taxes will apply to the amount you withdraw.
“If you are in the 22% tax bracket and are charged that additional 10% penalty, which would be an automatic 32% cut on your money just for federal taxes,” Kendall Meade, a certified financial planner with SoFi in Charleston, South Carolina, said. “Then you would also potentially owe state taxes.”
Beyond that, closing a 401k has a number of disadvantages:
- The IRS levies a 10% penalty.
- The money you withdraw is treated as taxable income, potentially at a higher tax rate.
- The investment potential of pre-tax deductions, employer matches and compound interest are lost when you close out a 401k.
- Money removed from a 401k account is no longer protected from creditors in case of bankruptcy.
Cashing Out Your 401k while Still Employed
Typically, you can’t close an employer-sponsored 401k while you’re still working there. You could elect to suspend payroll deductions but would lose the pre-tax benefits and any employer matches.
In some cases, if your employer allows, you can make an in-service withdrawal if you’ve reached the age of 59 ½.
Such funds can be used to cover a qualifying hardship. But you might also request an in-service withdrawal if your 401k plan offers few investment options, or you’re not satisfied with the options. You might consider expanding your options by rolling your 401k into an IRA.
Steps to Cash Out (If You Decide to Proceed)
The first step in the withdrawal process is to contact your human resources department and find out if the company’s 401k plan even allows for early withdrawals. Some don’t. Some do. Depends on the company, so start with a phone call to HR and ask if this option is available.
If your company’s plan does allow early withdrawals, you will need to contact the HR department or go online and request the amount needed. There will be paperwork for you to fill out that probably includes answering the question: Why do you need early access to this money?
The IRS allows withdrawals without a penalty for “immediate and heavy financial need” which is subject to interpretation. It’s best to consult with the IRS or research “immediate and heavy financial need” on their website to see if you qualify.
Make sure you take into account any penalties you will suffer – most prominently, the 10% tax for early withdrawal – before deciding on how much to take. Once the paperwork is approved, you should receive a check, minus of course, the tax penalties.
Alternatives to Cashing Out
If you don’t have an emergency fund to tap when a financial crisis hits home, there are still better ways to get money than withdrawing from a 401k plan. Those choices include:
- Personal loan: This is a low-risk alternative because there is usually no need to put up collateral for the loan and interest rates are affordable, if you have good credit.
- Home equity loan: This offers the lowest interest rate because you’re using your home as collateral. But it’s risky because you could lose the home if you’re not able to make payments.
- 0% balance transfer credit card:This could be a good choice, depending on how much you need to borrow and how committed you are to paying it back. You may be restricted to a small amount, depending on your credit score. If you qualify, you will have an introductory period (usually 12-21 months) to repay the loan before a high interest rate is slapped on your balance.
Debt Relief Without Closing My 401k
Before borrowing money from your retirement account, consider other options likenonprofit credit counselingor a home equity loan. You may be able to access anonprofit debt management planwhere your payments are consolidated, without having to take out a new loan.
A credit counselor can review your income and expenses and see if you qualify fordebt consolidationwithout taking out a new loan.
As they say, life comes at you fast. But help can be just a phone call away.
“If you’re facing financial difficulties, contacting a financial advisor or credit counseling service can provide guidance and support in managing your situation,” Call said.
