What You Should Know About Early 401(k) Withdrawals

Many people find it difficult to treat their retirement savings as being off-limits, particularly when immediate expenses arise. But taking early 401(k) withdrawals can mean sacrificing important tax benefits of your hard-earned plan contributions. It can also put you on the hook for tax penalties.

It's important that you understand the 401(k) early-withdrawal penalties and proceed carefully, whether you need a down payment for a new house, college tuition for your kids, or cash for a financial emergency.

401(k) Early-Withdrawal Penalties

The tax benefits are among the biggest advantages of contributing to a 401(k) plan. Not only is each traditional 401(k) plan contribution tax-deductible, but the money also grows tax-deferred while it's in the plan.

Your contributions reduce your taxable income, and by extension the amount you owe in taxes, in the year you make them. You'll put off paying income taxes on contributions and earnings until you take distributions.

Ideally, you wouldn't withdraw funds from your 401(k) until after you retire. You'd pay income tax on those withdrawals, but many people find that they're in a lower tax bracket in retirement than they were during their working years when they claimed tax deductions for their contributions. This can add up to some tax savings.

These tax benefits are only applicable when you abide by the rules of the plan, however. The rules limit everything from how much you can contribute annually to when you can withdraw funds from the plan penalty-free.

Not only will you owe income tax on the amounts you take out if you withdraw funds from your traditional 401(k) before you reach at least age 59 1/2, but the withdrawn funds will be subject to an additional 10% early withdrawal penalty tax as well, although exceptions to this rule exist.

Taking an early withdrawal can reduce the total amount you pocket by half after paying taxes and penalties. The tax hit can hurt your finances in the short term and could cost you in retirement by restricting your income, even if you qualify for penalty-free early withdrawals at that time.

Exceptions to 401(k) Early-Withdrawal Penalties

Several exceptions to the 10% penalty are intended to limit some of the financial loss in certain situations. Some 401(k) withdrawals made before you reach age 59 1/2 are exempt from the additional penalty under these circumstances:

• You die, and the account is paid to your beneficiary.
• You become disabled.
• You terminate employment and are at least 55 years old.
• You have unreimbursed medical expenses exceeding 7.5% of your adjusted gross income (AGI). This could potentially increase to 10% in tax year 2022.
• You begin substantially equal periodic payments. (See Rule 72(t).)
• Your withdrawal is related to a Qualified Domestic Relations Order pursuant to divorce.
• You took a qualified coronavirus-related early 401(k) withdrawal under the Coronavirus Aid, Relief, and Economic Security (CARES) Act between Jan. 1 and Dec. 30, 2020.
• You take a qualified disaster-related early 401(k) withdrawal (not for COVID-19) under the Taxpayer Certainty and Disaster Tax Relief Act of 2020 between Jan. 1, 2020, and June 24, 2021.

Stimulus and Other 401(k) Early-Withdrawal Considerations

It's not advisable to take an early distribution from your retirement plan just because you can—even if you can take one without penalties. There are other important criteria to consider when you're pulling money out of an account that's intended for your long-term use.

Investment Growth Prospects

You'll lose the potential future gains of that retirement plan money in addition to penalties and taxes due upon an early withdrawal. There are annual limits to the amount you can contribute to 401(k) plan, so you can’t make up for a previous withdrawal later.

"Catch-up" contributions are permitted for savers age 50 and older, but it would be much more difficult to save enough to recoup your lost earnings and compound interest by this time.

401(k) Loans

Although 401(k) loans have their own drawbacks, such as the need to make payments with interest, you might want to consider such a loan if you're in a financial bind, and your only option is your retirement money. A 401(k) loan might be preferable to an outright 401(k) withdrawal with penalties if you have the discipline to make on-time payments.

CARES Act Stimulus 401(k) Withdrawal Changes

President Trump signed the CARES Act into law in March 2020. It's a $2 trillion economic stimulus package intended to soften the health and economic impacts of COVID-19. The act included several provisions that allowed for more flexible use of retirement plans such as 401(k) plans to help cover emergency expenses, but some of them have since expired.

Penalty-Free Early Withdrawals

The CARES Act 401(k) provides that individuals under age 59 1/2 could take up to $100,000 in coronavirus-related early distributions from their 401(k) plans through Dec. 30, 2020, without facing the 10% early-withdrawal penalty under these conditions:

• You, a spouse, or a dependent were diagnosed with coronavirus.
• Your finances were impacted adversely because you were quarantined, furloughed, or laid off as a result of the pandemic.
• You couldn't work because the pandemic prevented you from obtaining child care.
• You owned or ran a business, and the pandemic forced you to close or reduce operating hours.

Congress additionally passed the Taxpayer Certainty and Disaster Tax Relief Act of 2020, which extended this benefit to victims of qualified disasters other than the pandemic in 2020. Anyone affected by an officially declared major disaster between January 1, 2020, and Feb. 25, 2021, could take qualified disaster distributions of up to $100,000 from their 401(k) through June 24, 2021, without penalty.

Recontribute What You Took out of Your 401(k)

The stimulus bill allows you to re-contribute to your 401(k) plan through one or more payments made within three years. These contributions won't count toward the usual 401(k) annual contribution limits.

Borrow More From Your 401(k)

The stimulus bill also doubled the limit on 401(k) loans from $50,000 to $100,000, up to a maximum of 100% of the vested account balance, but you had to take the loan from your 401(k) within six months from the time the stimulus bill was enacted. The deadline was September 23, 2020.

401(k) Required Minimum Distributions

You can defer taking distributions from your 401(k) plans until April 1 of the year following the year in which you reach age 72, or age 70 1/2 if you reached that age before July 1, 2019.

You must generally withdraw at least your required minimum distributions (RMDs) annually after that point, although exceptions apply. For example, the CARES Act waived all RMDs from 401(k) plans for 2020, including your first RMD.

Your RMD is calculated by dividing your account balance on December 31 of the previous year by a distribution period based on your life expectancy. The IRS provides life expectancy tables based on your marital status and beneficiaries. All three of the tables (Uniform Lifetime Table, Single Life Expectancy, and Joint Life Expectancy) can be found in Publication 590-B.

Failure to take your annual RMD comes with a steep penalty: 50% of the difference between what should have been distributed and what was actually withdrawn.