If you are in financial need, it might seem extremely tempting to withdraw some money from your 401(k), IRA, or other retirement account to cover the need. However, that withdrawal generally comes with a heavy penalty of 10% of the withdrawal amount.
Retirement accounts are intended for retirement, so the IRS imposes this penalty to discourage you from withdrawing money from your retirement savings.
But what if you are in genuine financial hardship? When can you withdraw from your 401(k) without this penalty? In some cases, you might be able to take some cash from your 401(k) without a penalty.
Here is everything you need to know about early withdrawals from your 401(k), plus some ways to cash out without a penalty.
Understanding Early Withdrawal From A 401(k)
A 401(k) is a retirement plan that allows you to make tax-deferred contributions into the plan and lets the investments grow tax-free until retirement age.
Since this money is supposed to be for retirement, it must remain in the account until you retire. Withdrawing money from your account should only be done in emergencies.
- Removing the money early will result in paying income taxes and a penalty.
Since a 401(k) is an employer-sponsored plan, your employer sets some rules regarding early withdrawal.
- Not every plan allows for early withdrawals.
You should first check your plan documentation to determine whether an early withdrawal will be allowed from your plan. You can also view the details of what qualifies for an early withdrawal and any documentation that may be required.
- It would help if you thought long and hard before taking any early withdrawals from your plan. You could consider other options, such as a personal loan or borrowing from friends or family.
Once you pay the income tax and early withdrawal penalty on your funds, you will likely only be left with about 60% of the money you removed from your account. This can put a massive dent in your account and set you back in your retirement planning goals.
KEY TAKEAWAYS
- If you withdraw from your 401(k) early, you typically need to pay a 10% penalty, and you owe taxes on the amount withdrawn.
- Each 401(k) plan has different rules, however, there may be options to withdraw funds early without encuring the 10% early withdraw penalty.
- Borrowing from your 401(k) if one of the few options that allows you to avoid the early withdraw penalty and also avoid immediately paying taxes on the funds.
Top Penalty Free 401k Withrawal Options
Once you decide that you must raid your 401(k) account to get money, consider all the options available to you. Perhaps there is a way that you can withdraw the money penalty-free.
Some 401(k) plans allow loans or other types of withdrawals without the big penalty that most early withdrawals incur.
Borrow From Your 401(k)
This can be an excellent option for those who need to use 401(k) money but do not want to pay the penalty. Not all plans allow for borrowing, and even if your plan does allow a 401(k) loan, you should only use it as a last resort.
It would help if you referred to your plan documentation for the specifics, but generally, here is how a 401(k) loan works. In most cases, no paperwork or documentation is required to qualify for the loan. This can be a great option because there is no credit check, and the loan will not appear on your credit report.
Generally, you must take a minimum loan of $1,000; the maximum amount allowed is $50,000. You can repay the loan over some time, up to 5 years, unless you are using the money as a down payment on a home.
In that case, you can extend the period up to 15 years. The interest rate on the loan is usually a couple of points above the prime rate, but the great thing is that you are essentially repaying the interest to yourself.
If you leave your employer while you have an outstanding loan, it will become due immediately. If you cannot repay the full amount, it will be taxed as an early distribution, including the 10% penalty.
Disability
If you become disabled and unable to work, you might be able to withdraw money from your 401(k) or individual retirement account (IRA) early without paying the penalty.
However, not just any disability will qualify you for this exemption. To meet the rules for this exception, the IRS requires you to be “totally and permanently disabled.”
So, what exactly does that mean? The IRS’s definition is quite similar to the one used by the Social Security Administration when determining eligibility for disability benefits.
One significant difference exists between the two, though. To qualify for disability benefits, the disability must only last for 12 months or longer. To be eligible for a waived penalty on your withdrawal, the IRS requires that the disability be permanent or last for the rest of your life.
- Just because the SSA has awarded you disability benefits does not mean you can waive the penalty for your early withdrawal, but it is a good start.
- You will be required to submit medical documentation along with your tax returns so that the IRS can determine whether your condition meets their definition of a disability.
They will want to see a doctor’s opinion that your disability will be permanent and that you are unable to perform substantial work of any kind.
You will use IRS Form 5329 to claim this disability exemption, and you must submit all your medical evidence to go along with it. Again, you will still be required to pay your regular income tax on the funds you withdraw.
Job Termination After Age 55
While the age for avoiding the penalty is usually 59 1/2, there is an exception to the age rule. If you leave a job or are terminated at age 55 or later, you can make withdrawals from your account with that employer without paying the penalty.
Make sure that you do not make withdrawals from any other plans you might have, as those will still be subject to the penalty.
Likewise, remember that there are even heavier penalties for missing required minimum distributions (RMDs). Upon reaching age 72, you must withdraw specific amounts from your account. If you fail to withdraw, you will receive a penalty of 50% of the required distribution amount.
Suppose you were required to withdraw $8,000 from your 401(k). If you miss that distribution, you will owe $4,000 in the penalty alone!
Roth 401(k) or Roth IRA Conversion
Since you can withdraw from your Roth account without a penalty at any time, you might consider converting your Traditional 401(k) to a Roth account.
You might even have the option to rollover to a Roth IRA, but there are some differences between an IRA and 401(k). You should check with your plan administrator to make sure this is allowed.
Also, note that you must pay income taxes when converting. Since you contribute to a traditional plan with pre-tax dollars and contributions to a Roth plan are with after-tax dollars, you will have to go ahead and pay taxes on those dollars when you perform the conversion.
Make sure you have enough cash on hand to cover those taxes. Once the conversion is complete, you can withdraw from your Roth account without any associated penalties.
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Less Common Penalty Free Withdrawl Options
Qualified Reservist
Certain military members are allowed to withdraw from their 401(k) or other retirement investment accounts without incurring the 10% penalty commonly associated with early withdrawals.
Several criteria must be met to qualify, and we will discuss those here. First, a reservist is a member of the military who is not active. However, when they are called to duty, this triggers the potential qualification to make the withdrawal. The service member must have been called to active duty after September 11, 2001. The deployment must last for more than 179 days or an indefinite period.
This exception exists to help these service members cover unexpected expenses associated with their deployment.
For example, a working spouse may be left at home, and unexpected childcare expenses may be incurred. The working spouse could be forced to quit work, placing an undue financial burden on the household.
As with the previous types of withdrawals, you should only take money from your 401(k) if necessary. Removing funds from your account will significantly affect your retirement nest egg, and it can take years to recover from even a small withdrawal.
Qualified reservists are also allowed to repay the withdrawal amount within two years of their active duty tour ending, even if the amount causes them to exceed their annual contribution limit.
This can be a great short-term option for military members who need extra financial assistance during their deployment.
Auto-Enrollment
Believe it or not, some employers automatically enroll their employees in a 401(k) plan. The Federal government encourages auto-enrollment, which is why the Pension Protection Act of 2006 created this exception.
Remember that a pension and a 401(k) are different, but they both help provide income for retirees. Instead of requiring employees to opt into the 401(k) plan, employers can now automatically enroll employees and allow them to opt-out.
This encourages saving for retirement and, in some cases, helps employees begin to build a nest egg without them even realizing it.
So, what happens to the money already deposited into the account when the employee opts out?
- You might be able to withdraw your contributions without paying that pesky 10% penalty.
If your employer has added the withdrawal option, you will have 90 days to withdraw your contributions from the account without penalty. The penalty will still be due if your employer does not add this feature. Either way, you will still pay your regular income tax rate on the funds.
Substantially Equal Period Payments (SEPP)
Substantially Equal Period Payments (SEPP) might be a good option if you need to withdraw money for a long-term need. These payments must last a minimum of 5 years or until you reach the average 401k withdrawal age of 59 1/2, whichever is shorter.
For this reason, this is not a good option if you have a short-term need like a sudden, unexpected expense. You cannot withdraw funds using this method if you still work for the employer through which you have the 401(k).
To calculate the amount of these payments, the IRS recognizes three acceptable methods.
Required Minimum Distribution Method
This will result in an annual payment to the recipient. The account balance is divided by the recipient’s life expectancy factor to arrive at the annual amount. The amount is recalculated each year based on the new account balance, but the life table used in the original calculation is used for the duration of the payments.
Fixed Amortization Method
With this option, the payment will be the same each year. It is calculated using the life expectancy table and a chosen interest rate. Once the amount is calculated, it will remain the same each year that the payments are made.
Fixed Annuitization Method
With this option, the payment will also be the same each year. However, the calculation for the payment amount is a little different. The amount is derived from the account balance divided by an annuity factor. This annuity factor comes from an IRS mortality table and a chosen interest rate. Again, it is based on the recipient’s life expectancy.
TIP
Borrowing or taking an early withdrawal from your 401(k) account should only be done after exhausting other options. These funds are designed to support you during retirement when you are no longer working.
Special and One Time Withdrawal Options
Hardship Withdrawal
Sometimes, a severe financial need will be enough to allow you to take a hardship withdrawal without the 10% penalty. The things that specifically qualify as a hardship will be spelled out in your plan documentation, and those will vary between employers.
However, a couple of conditions must always be met to qualify as a hardship.
- First, you must have an immediate and heavy financial need.
- Next, you can only withdraw enough money to cover that immediate need. You are not allowed to withdraw extra funds to spend money, make a payment on a credit card, or cushion your savings account.
Educational Expense
Education-related expenses like books and tuition typically qualify for a penalty-free withdrawal, so you might be able to withdraw some cash from your 401(k) account if you need it for school.
Purchase of a First Home
Purchasing a first home is another expense that can qualify you for a penalty-free withdrawal. You might be allowed to take up to $10,000 from your account to pay the costs of a first home purchase.
You should know that in these scenarios, you will still be required to pay income tax on your withdrawal at the rate for your specific tax bracket.
Medical Expenses
Medical expenses will often qualify you for a hardship withdrawal if you do not have the funds to pay them otherwise. You will likely also qualify if you are in imminent danger of foreclosure or eviction.
High Unreimbursed Medical Expenses
This exception is similar to the hardship distributions mentioned earlier, and these medical bills might qualify you under either category. You should know that a hardship withdrawal for medical bills will not entitle you to waive the 10% penalty in all cases.
The bills must be more than 7.5% of your adjusted gross income (AGI) to qualify for a penalty-free withdrawal. You must also take the distribution the same year the bills were incurred.
You cannot take money for estimated future bills either. The bills must be currently due for services already provided.
Also, note the requirement that the bills be unreimbursed. If your insurance covers part of the bills or will reimburse you for the payments, you cannot use your 401(k) money to pay them.
Likewise, the bills must be for you, your spouse, or a qualified dependent. You cannot use the money to pay bills for a parent, sibling, or any other family member.
The limit to the amount of money you can withdraw for medical bills was recently removed, so you can withdraw as much as is needed to cover all the expenses.
Death
A death is another way to access funds from a 401(k) without being subject to the standard 10% penalty. Obviously, you cannot withdraw upon your death, but the penalty exemption also applies to your beneficiaries.
If no beneficiary is listed with your plan, the account will become part of your estate and must go through the probate process. That can take a considerable amount of time, although your heirs will still be allowed access to the funds without the penalty at the end of probate.
We assume you have a named beneficiary for your account for this discussion.
Your plan administrator sets up the specific withdrawal rules for how the funds will be handled upon death. While the IRS sets the general framework and rules, your plan might have more restrictive rules than the Internal Revenue Service.
- Many plans allow the beneficiary to choose whether to receive periodic distributions or a lump sum. Either way, your beneficiary can withdraw the money without a penalty even if the deceased and the beneficiary are under age 59 1/2.
Most people choose the lump sum option, meaning they receive the entire account balance at once. While the penalty will be waived, you will still be required to pay income taxes on the funds, so getting a lump sum can result in a large tax bill at the end of the tax year.
If your spouse is your beneficiary, he or she also has other options.
- You could perform a rollover of the funds into an IRA. This prevents you from paying income taxes on the funds until you begin making IRA withdrawals.
Your financial advisor can help you decide between a Roth vs traditional IRA. Working with the plan administrator to perform a direct rollover would be best.
This means they will send the money directly to the brokerage where your IRA is located. If they send you a check instead, they must withhold 20% for federal taxes, and you must remember to deposit the check into the IRA within 60 days.
This can get tricky, so things are much easier with a direct rollover. Also, remember that you might be able to qualify for Social Security spousal benefits upon the death of your spouse, which can provide additional financial resources.
CARES Act Withdrawal
Due to the financial crisis created by the Coronavirus pandemic, President Donald Trump signed the CARES Act into law in March 2020. Among the provisions of this act were some situations that allow for penalty-free withdrawals from your 401(k) in 2020 due to COVID-19.
There are a few ways to qualify for a withdrawal under this act. You would qualify if you or your spouse were diagnosed with COVID-19.
- Next, you would qualify if you experience adverse financial consequences from being furloughed or laid off because of COVID-19.
- Finally, you will be qualified if you cannot work due to a lack of childcare or your own business suffers financial hardship due to COVID-19.
If you qualify and take the withdrawal during 2020, the 10% penalty for early withdrawal will be waived. However, you will still owe income taxes on the withdrawal, although you can spread the taxes over three years.
For example, if you withdraw $12,000 from your 401(k), you can claim $4,000 of income in 2020, 2021, and 2022. You may also choose to claim the entire amount in the year in which you receive the distribution.
The Bottom Line
While you should do everything possible to avoid raiding your retirement funds, there are some cases when it becomes necessary.
You already know that you will be paying taxes on the funds you withdraw as ordinary income, but you will also be charged a 10% penalty in most cases.
However, in certain situations, that penalty is waived. We have discussed several ways to take an early withdrawal from your retirement savings account without being forced to pay that extra penalty.
If you absolutely must withdraw that money from your account, you should ensure the withdrawal fits into one of the exceptions discussed here to save yourself some money on the tax penalty.
If you are unsure whether your situation qualifies for an exception, you should consult your financial advisor for help.
Frequently Asked Questions
The rules can vary by plan, and plan participants should always consult their plan documentation to see the specific rules that will apply.
Remember that even with a solo 401(k), you should have your rules written down and documented.
However, a couple of basic rules will always hold true when it comes to a hardship 401k withdrawal.
- First, the withdrawal must be for an immediate and heavy financial need.
- Next, you can only withdraw enough funds to cover that immediate need.
For example, missing a mortgage payment typically does not qualify as an immediate and heavy need; however, if you have received foreclosure papers and are in danger of eviction, that constitutes an immediate and heavy need.
Again, you should contact your plan administrator with any questions about the hardship requirements for your qualified plan.
It depends on when you make the withdrawal. If you are age 59 1/2 or older, then there is no tax penalty.
However, if you withdraw before reaching this age, you will be charged an extra 10% penalty on top of your regular income taxes that you pay on the funds.
In some cases, you might be able to withdraw without being required to pay the penalty. Some situations include hardship withdrawals, unreimbursed medical expenses, education-related expenses, qualified reservists, and death.
This is not an exhaustive list. You should contact your financial planner to discuss your specific situation and see if you can qualify for a penalty-free withdrawal.
Unless you fall into one of the special exemption categories, you will pay a penalty of 10% of the funds you withdraw.
This can get quite pricey and cut into your retirement savings. If you must make a withdrawal before reaching retirement age, then make sure you check the list of exemptions to the penalty.
If you qualify under one of the exemptions, you will not be forced to pay this extra penalty.
With a 401(k) loan, you must repay the money in your account over time. With a standard withdrawal, there are no repayment requirements.
You will be charged interest on the loan, although you are technically paying the interest back to yourself. The money goes back into your 401(k) account, and you usually can spread the payments out for up to 5 years.
If you use the money for a down payment on a home, you can even spread it over 15 years. A loan is usually a much better option than a withdrawal because you will at least replace the money.
However, not all plans offer 401(k) loans, so that might not be an option.
You can find a Social Security Administration office near you by using our SSA office locator and searching for your closest location.
