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Updated on Thursday, December 10, 2020
If you have a decent retirement fund set up, you might be able to take money out with early withdrawal from your 401(k). Before jumping ahead to take money away from your retirement, make sure you know what’s at stake with an early 401(k) withdrawal.
Finding money for an emergency isn’t easy. The Federal Reserve Board says 40% of Americans can’t cover a $400 emergency. Whatever unexpected cost comes up, you might not be able to afford it.
What are the rules for an early withdrawal?
If all goes well, you won’t be taking money out from your retirement fund until you’re retired. The age of retirement varies by retirement plan, but can be as early as 59 and a half years of age. But if you’re going to take money out before hitting retirement age, you might get hit with a tax penalty.
A 10% tax penalty can apply for early withdrawals, whether it’s on a qualifying 401(k) or IRA plan. That means when you take money out, you’ll pay an extra 10% in taxes on your withdrawals. The taxable amount of the distribution could also place you in a higher tax bracket than if you didn’t make the withdrawal.
When you take money out in your retirement years, you may be living on a lower fixed income than when you were in your working years. An early withdrawal means you may face a higher tax rate on the distributions due to your working status.
Exceptions to an early withdrawal penalty
While a 10% tax penalty may apply, you might be able to avoid it if you’re experiencing financial hardship.
Hardships can vary depending on your situation and retirement plan. Your 401(k) plan may request you to provide proof of your financial hardship to qualify for early withdrawal.
Hardships can include:
- Certain medical expenses
- Homebuying expenses
- Education tuition and fees
- Foreclosure and eviction avoidance
- Funeral expenses
- Home repairs
A hardship distribution won’t be more than what you need to cover the cost of your emergency. So if you need $2,000 to make a home payment to avoid foreclosure, your early withdrawal will be for that amount.
Early withdrawal vs. 401(k) loan
Instead of taking money out of your account early, you could take out a 401(k) loan instead.
A 401(k) loan is where you borrow money from yourself. It’s a loan in a very broad sense: you’re the lender and the borrower. But it’s still a loan that you’re repaying with interest — to yourself.
When you take out a 401(k) loan, you’ll get a repayment plan crafted best for your budget. Most loans have a maximum term of five years. If you’re using your 401(k) loan to buy your primary residence, that duration could get extended up to 15 years.
Here are some differences between a 401(k) loan and an early withdrawal due to hardship:
|401(k) loan||Hardship distribution|
|Borrowing money to be repaid with interest.||Money does not need to be repaid.|
|Repayment plan established.||If repaying, can do so on your own terms.|
|Can borrow up to 50,000 or 50% of your vested 401(k) balance, whichever is less.||Can borrow only the cost of the financial hardship.|
A loan might be a good idea if you want to replenish your retirement account, but adding interest might end up costing you more than if you were to take a hardship distribution.
Problems with early withdrawal from your 401(k)
Being able to access your retirement funds without getting penalized is a great way to cover unexpected costs. Since an emergency can be detrimental to your finances, having a crutch is helpful. But there are some downsides to taking money away from your retirement.
Difficult to catch-up
While not required to repay your 401(k) if you take money out for hardship, you might want to. But even great intentions can hold you back.
Annual limits mean you can only contribute up to $19,500 for the 2021 tax year— plus another $6,500 in catch-up contributions if you’re 50 years of age or older. If you max out your 401(k) anyway, you’ll never be able to add back what you took out.
Lowering your compound interest
401(k) plans tend to work off compound interest — or interest that builds on top of interest. The less money you have in your account, the less interest — and in turn, less compound interest — that builds to increase your wealth.
Your hardship might not qualify
Emergencies vary in severity, which means yours might not get you an early withdrawal. The penalty exceptions are broad, but make sure your reasons qualify you to be exempt from taxes and fees.
Your plan may not qualify
Not all 401(k) plans allow you to make an early withdrawal. All plans have different requirements for what you need to showcase your hardship. Because of this, your plan may not allow an early withdrawal for a specific hardship while another one might.
It’s important to understand your plan details before applying for an early withdrawal from your 401(k).
Needing money for an emergency is difficult no matter what your situation is. Being able to take money out of your 401(k) to cover expenses can save you and your finances.
But you may not qualify for an early withdrawal, depending on your plan or hardship. Catching up is difficult and also takes away potential earnings. Take the time to review your plan and how it will impact your retirement later in life.