Before you decide to go ahead and cash out your 401(k), you need to consider the withdrawal penalties and taxes that apply. When you withdraw from your 401(k) plan before the eligible age cut off, the IRS levies a 10% penalty against the funds in your account when you file your tax returns.
Additionally, the IRS also withholds 20% of the 401(k) contributions as income tax on early withdrawals. The taxes withheld might actually be refunded if the amount you owe in taxes is less than the taxes withheld.
So that’s about 30% of your 401(k) contributions deducted against taxes and penalties. Withdrawing from your 401(k) is generally recommended only as a last resort for this very reason.
Exceptions to early withdrawal penalties
While the withdrawal penalties are pretty much a given, there are certain situations where the IRS waives the early withdrawal penalties.
- You become permanently disabled.
- You die and your contribution to your 401(k) are paid out to your beneficiary.
- Your 401(k) contribution is part of a divorce settlement.
- You are over 55 years old and are no longer employed.
- You choose the Substantially Equal Periodic Payments (SERP) after you stop working.
- You had a child during that tax year (this includes adoption).
- You transferred the amount in your 401(k) to an IRA or any other retirement account.
- You withdrew the amount under a Covid-19- related issue as outlined in the CARES Act between January 1 and December 30, 2020.
- You qualified for an early withdrawal due to a disaster-related incident as outlined in the Taxpayer Certainty and Disaster Tax Relief Act.
While these exceptions listed above are free from the early withdrawal penalty, income tax rates will still apply to the withdrawal. When applying for a withdrawal in the above-mentioned circumstances, you have to be sure to have all the right documentation.
Alternatives to a withdrawal
You don’t have to withdraw the entire amount from your account, you can choose to withdraw how much you need to get by as a loan against your 401(k). This works like a regular loan that you have to repay with interest, except the amount is deducted from your monthly paycheck.
This is another way to get a waiver on the penalty fee. This provision allows you to withdraw the funds in your 401(k) account if “it is due to an immediate and heavy financial need”. Hardship withdrawals are applicable for:
- Paying medical bills for you or your spouse.
- Paying college tuition or any education-related fees for you or your spouse.
- Paying rent to avoid eviction or foreclosure.
- Paying for repairs to any damage in your home.
- Paying for a funeral.
Convert it to an IRA
If you really need the money, consider converting your 401(k) to an IRA. The rules for withdrawal and the penalty fees differ in an IRA. The IRA does not have any taxes withheld when you make early withdrawals so you can actually pull out 100% of your contribution without paying any penalties.
Substantially Equal Periodic Payments (SERP) allow you to withdraw money from your retirement account early according to a specified schedule. This schedule usually involves payment split across 5 years or until you reach the age of 59 and a half—whichever comes last. The rules for this type of payment are outlined in the IRS code section 72(t).
CARES Act stimulus
The Covid-19 pandemic resulted in the signing of the CARES Act, a stimulus package that was created to make it easier to access funds in a retirement account early. These flexible rules allow withdrawals to cover emergencies. The waiver on the penalty fee includes situations where:
- Your lack of employment due to the pandemic affected your ability to obtain child care.
- You or your dependent(s) contracted Covid-19.
- You lost your job.
- Your business was affected by the pandemic.
Ideally, your 401(k) contribution should be withdrawn when you retire so only make that decision to withdraw early if you have no other options.