Making an early withdrawal from your 401(k) might sound like a tempting idea initially - after all, it is your money. But once you know the ramifications, you may feel differently.
There are two types of 401(k)s: traditional and Roth. The traditional option allows you to set aside dollars for retirement on a tax-deferred basis, meaning that your taxable income is reduced by the amount of the money you set aside in a calendar year. Your money grows tax deferred until the tax code allows you to begin making penalty-free withdrawals after age 59 1/2 .
With the Roth option (not offered by all employer plans), your money also grows tax deferred, but your contributions are made on an after-tax basis. That means your current taxable income is not reduced, but you don't owe taxes on the withdrawals in retirement.
Matching contributions from an employer (if applicable) are deposited in a traditional 401(k) account and you'll pay taxes on any distributions taken, even if you opt to contribute your own funds to a Roth 401(k).
Here's what you need to know if you're considering taking an early withdrawal from your 401(k) and some alternatives that may prove to be better options for your financial situation.
An unexpected job loss, illness or other emergencies can wreak havoc on family finances, so it's understandable that people may immediately think about taking a withdrawal from their 401(k). Tread carefully as the decision may have long-range ramifications impacting your dreams of a comfortable retirement.
Taking a withdrawal from your traditional 401(k) should be your very last resort as any distributions prior to age 59 1/2 will be taxed as income by the IRS, plus a 10 percent early withdrawal penalty to the IRS. This penalty was put into place to discourage people from dipping into their retirement accounts early.
Roth contribution withdrawals are generally tax- and penalty-free (as long as the withdrawal occurs at least five years after the tax year in which you first made a Roth 401(k) contribution and you're 59 1/2 or older). This is because the dollars you contribute are after tax. Be careful here because the five-year rule supersedes the age 59 1/2 rule that applies to traditional 401(k) distributions. If you didn't start contributing to a Roth until age 60, you would not be able to withdraw funds tax-free for five years, even though you are older than 59 1/2 .
You can withdraw funds early from your Roth 401(k) prior to age 59 1/2 if you haven't met the five-year rule noted above, but with a caveat. Because your withdrawal must include both your own contributions and earnings on those contributions, your withdrawal must be prorated based on the percentage each constitutes in your portfolio. So although any contributions you've made are withdrawn tax-free, earnings on those contributions would be taxed as regular income and subject to a 10 percent tax penalty.
If your employer's plan allows it, a hardship withdrawal from a traditional or Roth 401(k) to address "an immediate and heavy financial need" is another way to gain access to your money. This type of withdrawal permanently reduces your portfolio's balance and you're taxed as noted above.
Tax rules do not allow you to pay this money back or "put it back" in your account after the hardship has passed and your financial situation improves. After taking such a withdrawal, some companies bar you from contributing to the plan for six months or more, further compounding your loss of retirement savings especially if you are missing out on a company match.
For those contemplating a hardship withdrawal, remember your 401(k) is meant to provide income in retirement and should not be tapped for other reasons unless your situation is truly dire.
The following limited number of situations rise to the level of "hardship," as defined by Congress:
Your plan may or may not limit withdrawals to the employee contributions only. Some plans exclude income earned and or employer matching contributions from being part of a hardship withdrawal.
In addition, IRS rules state that you can only withdraw what you need to cover your hardship situation, though the total amount requested "may include any amounts necessary to pay federal, state or local income taxes or penalties reasonably anticipated to result from the distribution."
"A 401(k) plan - even if it allows for hardship withdrawals - can require that the employee exhaust all other financial resources, including the availability of 401(k) loans, before permitting a hardship withdrawal," says Paul Porretta, a compensation and benefits attorney at Troutman Pepper in New York.
401(k) loans are generally considered to be a better option than a hardship withdrawal if given the choice since you're essentially borrowing from yourself. Not all plans allow loans - although it is a fairly common feature - so be sure to check with your employer. Even when they're allowed, there are specific rules you must follow to avoid penalties and taxes.
The amount you can borrow is defined in your employer's plan, but typically it's limited to 50 percent of the vested value of your account up to a maximum dollar amount (typically $50,000, save for exceptions made as part of the CARES Act). There is usually a loan minimum as well. You can find out how much you can borrow by viewing your account online, speaking to a plan representative or contacting your HR department.
Although getting a loan from your 401(k) is relatively quick and easy, the benefit of paying yourself back with interest will likely not make up for the return on investment you could have earned if your funds had remained invested.
Another risk: If your financial situation does not improve and you fail to pay the loan back, it will likely result in penalties and interest.
A 401(k)participant with a $38,000 account balance who borrows $15,000 will have $23,000 left in their account. If that same participant takes a hardship withdrawal for $15,000 instead, they would have to take out $23,810 to cover taxes and penalties, leaving only $14,190 in their account, according to a scenario developed by 401(k) plan sponsor Fidelity. Also, due to the time value of money and the loss of compounding opportunities, taking out $23,810 now could result in tens of thousands less at retirement, maybe even hundreds of thousands, depending on how long you could let the money compound.
It should be noted that the CARES Act of 2020 gave employers the option to amend their 401(k) plans only if they so choose to allow "investors who are impacted by the coronavirus to gain access to [more] of their retirement savings without being subject to early withdrawal penalties and with an expanded window for paying the income tax they owe on the amounts they withdraw" per The Security and Exchange Commission's (SEC) Office of Investor Education and Advocacy (OIEA).
"An employer could amend their plan by allowing coronavirus-related distributions but not increasing the 401(k) loan limit," according to Porretta.
The SEC's OIEA guidance on the CARES Act allowed "qualified individuals impacted by the coronavirus pandemic to pay back funds withdrawn over a three-year period (2020, 2021 and 2022), and without having the amount recognized as income for tax purposes."
For income taxes already filed for 2020, an amended return can be filed. The 10 percent early withdrawal penalty was also waived for withdrawals made between Jan. 1 and Dec. 31, 2020. It also waived the mandatory 20 percent withholding that typically applied.
The Act also allowed plan participants with outstanding loans taken before the Act was passed but with repayment due dates between March 27 and Dec. 31, 2020 to delay loan repayments for up to one year. (However, the regular interest rate continues to apply).
If any of these apply to you, you can likely access your money early without having to pay the penalty.