A 401k can be a powerful savings and investing tool for millions of people! Not only does a 401k invest in various securities that can appreciate overtime, there are also tax benefits and incentives to invest in a 401k.
In a world where pensions are becoming less common, employer sponsored 401k retirement plans are becoming increasingly more popular and important. With that said, there is a 401k early withdrawal penalty if you pull your money out before retirement.
We’ll help address this and much more of the common 401k early withdrawal questions and concerns below.
What Is a 401k?
Before diving into some of the granular details of a 401k early withdrawal penalty, let’s review what a 401k is. Simply put, a 401k is an employer-sponsored retirement plan.
An employee can elect to contribute a percentage of their paycheck to a 401k, and it’s common for employers to match a percentage of their contribution. A 401k invests in underlying securities, such as various stocks, mutual funds, bonds, and ETFs. These investments tend to grow overtime, and can provide the employee with a nest egg in their retirement years.
There are tax benefits to a 401k as well. You can allocate money to your 401k pre-tax, and ideally, in retirement your tax rate would be lower than what it was during your working years. This allows your money to grow more aggressively, leaving you with a larger account balance in your retirement years.
How Does Withdrawing Early From a 401k Work?
By definition, a 401k is a retirement plan. There is a penalty for tapping into your 401k account before you reach your retirement years. With that said, there are a few reasons why someone would want to, or need to, withdraw from their 401k before they reach their retirement years.
Most commonly, these reasons include:
- Unforeseen medical expenses
- Purchasing a home
- A temporary rough financial period
Withdrawing from your 401k early is not illegal, nor is it impossible. At any moment, one can pull money out of their 401k. With that said though, there is a penalty to do so.
Can You Withdraw Your 401k Early Without Penalty?
As mentioned above, there is a penalty for withdrawing money from your 401k before you reach retirement age, or age 59 ½. However, you can withdraw money earlier, and in some instances, you can do so penalty free.
If you’re wondering how to avoid an early withdrawal penalty on your 401k, here are some of the most common qualifying reasons:
- You’ve became disabled and need the income
- Leaving your job and rolling the money over to another retirement account
- Needing to use the money as a downpayment to purchase a home
- You need money for a funeral expense
- You use the money to cover college tuition or room/board
401k Early Withdrawal Penalty
If you are withdrawing money from your 401k early, and you do not have a qualified reason to not receive a penalty, the IRS will penalize you for doing so. Penalties include a 10% fee on whatever you withdraw, and getting taxed, above and beyond the 10% penalty, on what you withdraw.
How Much is Taxed on 401k Early Withdrawal?
The money you withdraw from your 401k is taxed at your normal taxable income rate. As mentioned above, this is in addition to the 10% penalty!
For example, if you are looking to withdraw $20,000 from your 401k, and your tax rate is 20%, expect to only take home $14,400. Here’s the breakdown:
- $2,000 would go to the 10% penalty
- $3,600 would go to taxes (20% of $18,000)
What Is the Cares Act 401k Withdrawal?
COVID-19 brought financial hardship on millions of Americans and people worldwide. The United States Government recognized the hardship COVID-19 presented to individuals, and created the Cares 401k act.
Simply put, the Cares Act 401k Withdrawal allows one to withdraw up to $100,000 from their 401k if they experienced financial hardship from the COVID-19 pandemic, penalty free. Penalty free doesn’t mean you wont pay taxes though.
The money you withdrew will still be taxed at your normal income tax rate. However, you can do one of two options:
- You can pay the tax back over 3 years
- Or, if you repay the withdrew balance back in full within 3 years, the tax obligation is waived
Who Is Eligible for Cares Act 401k Withdrawal?
The IRS has a certain criteria that defines who is eligible for cares act 401k withdrawal. One would be eligible for this benefit if they experienced financial hardship resulting from COVID-19.
Financial hardship includes; one losing their job, one was forced to quarantine for an extended period of time, one experienced furlough and/or reduced pay or hours worked, or their business shut down.
Benefits of Withdrawing Early on a 401k
Despite the taxes and fees one must pay if they withdraw early on their 401k, there are still some benefits:
- If the money you withdrew allows you to stay out a high interest debt, you may end up on the right side of the equation when factoring in the all in cost of early 401k withdrawal
- You can use this money to purchase a home
- If you have a qualified life reason, such as college tuition, you can advance your future and multiply your earning potential if you used your 401k to pay for college.
Disadvantages of Withdrawing Early on a 401k
The benefits are nice, but they cannot be made without factoring in all the disadvantages. These disadvantages include:
- There is a steep price to pay for early withdrawal if you do not have a life qualifying event/expense
- The money you withdrew is not earning the interest rate it did within the 401k program, which will reduce the amount of money you have in retirement
- The money could be used for whatever you like, which may lead to unnecessary purchases
5 Steps for Withdrawing Early on a 401k
If you need to withdraw from your 401k early, the following 5 steps will guide you through the process.
Step 1: See If You Qualify to Be Exempt From Tax Penalties
First and foremost, see if the reason why you’re withdrawing money qualifies you to be exempt from the 10% penalty. If it does, you’re in luck!
Step 2: Do You Qualify for Hardship Withdrawal?
If the standard exceptions do not apply to you, don’t give up hope. There are also hardship withdrawal options, which can also reduce the 10% penalty fee.
An example of a hardship withdrawal would be the money being used for a funeral expense, medical bills, or purchasing a home.
Step 3: Consider Rolling Over Your 401k Into an IRA
You can also consider rolling your 401k into an IRA. The reality is, IRA’s tend to have more lenient withdrawal rules, so one of the ways you may be able to withdraw from your 401k without paying a penalty is to first convert your 401k to an IRA.
Once the money has cleared and you’ve passed the ‘waiting period’ you may be able to withdraw from your IRA without needing to pay the 10% fee.
Step 4: Use a 401k Early Withdrawal Calculator
If the above 3 steps are not an option for you, and you want to get a better understanding of how much money you’ll owe by withdrawing early from your 401k, use this early 401k withdrawal calculator. Simply follow the steps and enter the required information.
The calculator will help determine exactly how much money you may owe.
Step 5: Withdraw
Once you’ve considered all the above and you need to move forward with withdrawing money, you can typically do so from the comfort of your home. Your employer can guide you in the direction of your plan administrator if you do not know who it is, and there is typically an online portal that can walk you through the process.
If an online portal isn’t available, you’ll be able to reach the administrator over the phone where they’ll have a few steps for you to follow to withdraw your money.
Should You Withdraw Early From Your 401k?
Without question, 401k early withdrawal is something that cannot be taken lightly. There are a lot of moving pieces that must be taken into consideration before fully understanding if this is the right decision for you or not.
Considering the importance and potential ramifications of this decision, you should certainly use Personal Capitals early 401k withdrawal calculator before making this decision. This calculator will help you get the fully baked picture of the true cost of withdrawing from your 401k.
Frequently Asked Questions
An early 401k withdrawal is in fact considered income.
The money you withdraw from a 401k will be taxed at your normal income tax rate.
There are various ways one could avoid paying a penalty on withdrawing from their 401k early. Life qualifying events, such as purchasing a home, paying for a funeral expense, or paying for a medical expense, are all reasons that allow you to withdraw money penalty
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