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Cashing out all or a portion of your 401K might seem like a good idea if you’re in debt or in need of a quick cash infusion, but it can be very costly because of taxes and early withdrawal penalties.
Here are some frequently asked questions about 401K withdrawals and some of the rules you should keep in mind if you’re considering withdrawing money from your 401K.
401K Withdrawal FAQs:
What is the Penalty for a 401K Withdrawal?
In general, when you make a withdrawal from your 401K before you reach age 59 ½, the Internal Revenue Service may charge you a 10% early withdrawal penalty. You’ll also pay taxes on any amounts you cash out because these funds come directly from your pre-tax income.
There are certain circumstances, however, in which you can access your 401K funds without taking a financial hit, which we review here.
What is a 401K hardship distribution?
If your employer plan provides for hardship distributions, you can take a portion of your 401K funds to assist in paying for some specific expenses without paying the standard 10% early withdrawal penalty.
Each employer plan is different, though, so even if your plan allows for hardship distributions, they may not allow for the particular use you have in mind. For example, some plans may allow for medical or funeral expenses but not for tuition and education expenses. Before considering a hardship distribution, be sure to read your particular plan’s hardship language to determine if your need is eligible, but in general, some of the expenses that can be covered using a hardship distribution include:
- Tuition, including room and board, for yourself, your spouse, dependents and certain beneficiaries
- Medical expenses for yourself, your spouse or dependents
- Purchase costs for your principal residence, not including mortgage payments
- Costs related to avoiding foreclosure on or eviction from your principal residence
- Repair costs for damages to your principal residence
- Funeral expenses for deceased parents, spouse or dependents
Don’t forget the tax consequences: Even though the early distribution penalty will be waived on your approved hardship distribution, any withdrawal you make will be taxed as regular income, so you’ll want to consider what that means for your bottom line, plus review whether you’re pushing up against a higher tax bracket when taking the withdrawal amount into consideration. You can start your research by talking to your employer’s human resources department and then an accountant or other trusted financial professional.
Are there other penalty-free 401K withdrawals?
Other situations that can qualify for early, penalty-free withdrawals include:
- Qualifying disabilities
- Court orders requiring that funds be given to your former spouse or a dependent
- Disasters that have been granted relief by the IRS
Again, however, state and federal taxes are still effective for any amounts withdrawn.
How does a 401K loan compare to a withdrawal?
If a hardship distribution isn’t an option under your plan, you may be eligible to take a loan against your 401K. You’ll also avoid not only the early withdrawal penalty, but the taxes as well. Keep in mind, though, that most financial experts advise against taking a 401K loan unless you’ve exhausted all other alternatives. By taking out the loan, you’re removing money from your investments, which, depending on how the markets are performing could set you back significantly in your efforts toward saving for retirement.
The advantages: If you’ve looked at every other possible option, a 401K loan can at least give you a lower interest rate than other loan options, but the difference will likely not make up for the hit to your retirement savings. Another positive of a 401K loan is that the repayments are automatically deducted from your paycheck.
The disadvantages: Should you leave your job before paying back the full amount, you’ll likely be required to repay the loan balance within 60 days. If you don’t, that loan now qualifies as an early withdrawal, so you’ll get hit with that 10% penalty, plus income taxes on the remaining balance.
What about 401K withdrawals after age 59 ½?
Once you reach age 59 ½, you may begin withdrawing funds from your 401K without penalty. You can choose a lump-sum distribution or periodic distributions based on your personal needs. It’s a good idea to talk to your financial planner to decide what option is best for you, but keep in mind you’ll pay income taxes on lump-sum distributions right away. You can, however, just leave your retirement funds where they are until you reach age 70½, when the IRS requires that you begin taking distributions.
Are there good alternatives to early 401K withdrawals?
If you have a non-qualifying hardship, such as significant credit card debt that you can’t see a way to pay off, you can consider other options like credit card debt consolidation.
If your debt hasn’t already tanked your credit scores, you may want to see if you qualify for a personal loan or even apply for a credit card with a lengthy 0% APR financing for balance transfers. Some cards, like the Citi Simplicity, offer terms as long as , which can give you the breathing room you need to get your principal debt paid down. (Full Disclosure: Citibank advertises on Credit.com, but that results in no preferential editorial treatment.)
If you own your own home, you can also consider a home equity line of credit (HELOC). This option allows you to borrow against whatever equity you might have in your home. With both options, you’ll avoid the 10% penalty and will keep your 401K investments working for you.
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This article has been updated. It was first published December 9, 2016.