Why early withdrawal from your 401(k) should be your last resort

The 401(k) is a great tool to build your retirement fund. Withdrawing from your 401(k) is generally recommended only as a last resort.

Your 401(k) gives you some pretty sweet tax breaks—if you don’t pull out of the plan before you turn 59 years old. However, when times are tough and you need an influx of cash, taking money out of your 401(k) to stay afloat is an option you could consider. But what are the repercussions?

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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 

401(k) loan 

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.  

Hardship withdrawal 

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. 

SERP 

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. 

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This page is purely informational. Line does not provide financial, legal or accounting advice. This article has been prepared for informational purposes only. It is not intended to provide financial, legal or accounting advice and should not be relied on for the same. Please consult your own financial, legal and accounting advisors before engaging in any transactions.

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