A 401(k) plan is designed to provide people with a form of retirement income. Ideally, you routinely add money to your account and leave it untouched until retirement arrives. Unfortunately, life doesn't always work as planned. Sometimes events happen that require you to take an early withdrawal.
Before you do withdraw, it's important that you understand that those accounts don't operate like regular savings accounts; there are big penalties for early withdrawals. Here's what you need to know.
Types of 401(k) withdrawal penalties
The Internal Revenue Service (IRS) charges a 10% early-withdrawal penalty for withdrawing money from a 401(k) before age 59½. The penalty doesn't take into account taxes you may be obligated to pay on your withdrawal since, depending on the type of account you own, you may not have paid taxes yet on the income that produced it. In that case, in addition to the 10% penalty, you'll pay your regular tax rate. As an example, if your tax rate is 25% and you withdraw $10,000 from your 401(k), you'll pay a $1,000 penalty and $2,500 in taxes, which means you will net only $6,500.
Allowed withdrawals without penalty for 401(k) accounts
If you're in a dire situation in which you have no other choice but to withdraw money from your 401(k), there are some general exceptions built in for withdrawing penalty-free:
- If your unreimbursed medical expenses are in excess of 10% of your adjusted gross income and you need money to pay those bills
- If you've become permanently disabled, and you make early withdrawals to help meet daily living expenses
- If you're a military reservist called to active duty for more than 180 days, and you make withdrawals while in service
- If you resign, retire or are fired from the company sponsoring your 401(k), you are at least age 55 and you want to withdraw your entire account
- If a court orders payment to be made to another person (e.g., spouse or children).
There are still other exceptions you may qualify for in making a withdrawal.
401(k) hardship withdrawals
For financially strapped people, there are special rules ("hardship withdrawals") allowing access to the 401(k) money they need. They enable you to make a withdrawal before age 50½ if you need money for the following reasons:
- Purchase a primary residence
- Prevent foreclosure
- Pay for funeral expenses
- Perform essential home repairs
- Cover tuition or educational expenses
Many, but not all 401(k) plans allow for those. Before withdrawing, always check to see what your plan allows.
Be prepared to prove necessity
No 401(k) plan will allow you simply to withdraw without proving your hardship. To avoid penalties, you must demonstrate your need and show that you don't have other financial resources. Also, remember you must report early withdrawals to the IRS. It's usually not a good idea to withdraw from your retirement account unless you have an absolute need and no other options. Keep in mind that early withdrawals mean less money when you reach retirement age, a time when your financial income and other resources are typically much lower.