If you withdraw early from a 401(k), an individual retirement account (IRA) or any other tax-advantaged retirement plan before you reach 59 ½, it might end up costing you significant financial penalization. Those repercussions may be worthwhile in certain cases, and they may even be wholly avoidable. This article will help you figure out whether a 401(k) early withdrawal is a good idea for you.
What is a 401(k) Early Withdrawal?
Let’s start with a recap: Any money taken out of your retirement account before you reach federal retirement age (59 ½ currently), is referred to as a 401(k) early withdrawal. On top of any applicable income taxes, all withdrawals classed as early will get charged a 10 percent fee by the Internal Revenue Service (IRS).
Early withdrawal fees from a Roth 401(k) are normally only 10% of any investment growth withdrawal. Contributions are not included in the early withdrawal charge computation for this kind of plan.
- Also Read: 3 Reasons Certain Federal Employees Can Retire Years Earlier Than Their Peers Without Penalties
- Also Read: CSRS Retirement in 2024: Are You Making the Most of What This Classic Plan Has to Offer?
- Also Read: Roth IRA Basics for Beginners: What’s There to Learn?
If you’re taking an early withdrawal from a standard 401(k), however, the whole account amount is used to calculate the cost (k). Early distributions from a conventional IRA are also subject to these limitations.
How to Avoid the Penalty for Early Withdrawal
Several exceptions apply to the minimum age of 59 ½ rule. “The IRS allows penalty-free withdrawals in certain situations, such as death, disability, medical bills, child and/or spousal support, and military active duty,” explains a financial advisor at Betterment’s 401(k) Bryan Stiger (CFP).
But don’t worry if you don’t meet any of those requirements. If you’re a bit under the retirement age or schedule your withdrawals systematically, you have a handful of choices that may allow you to make withdrawals without penalties.
Stiger says that if you’re between the ages of 55 and 59 ½ and lose your employment, the IRS will enable you to take a penalty-free withdrawal from your 401(k) plan. That is known as the Rule of 55, and it’ll apply to anyone in this age bracket who is left without a job, regardless of the reason (fired, laid off, or quit voluntarily). To be eligible for the Rule of 55, your 401(k) must be at the firm from which you’ve just parted ways. IRAs, however, are exempt from the Rule of 55.
According to Stiger, “there is the Substantially Equal Periodic Payment (SEPP) exemption, too, or an IRS Section 72(t) distribution.” You can withdraw equal payments from your 401(k) on the basis of life expectancy using SEPP. Contrary to the Rule of 55, SEPPs allow you to withdraw early from an IRA.
Other Options Instead of Early 401(k) Withdrawals
If you really have to withdraw funds from your 401(k) and are unable to employ an authorized early withdrawal exception, the rule of 55, or SEPPs, you still have a few options to access your 401(k) money.
A 401(k) Loan
A 401(k) loan allows you to borrow from your retirement savings without paying penalties or taxes if you repay it within 5 years. 401(k) loans let you borrow up to $50,000 or half of your vested account balance (the lower of the two). Borrowing for various purposes, such as a down payment on a home, may allow you to extend your repayment duration.
401(k) loans, on the other hand, come with a huge catch. If you quit your job, either voluntarily or involuntarily, you’ll have very little time to pay off the entire loan. This is usually less than a year but at the latest by Tax Day the following year. If not, your loan will be classed as an early withdrawal, with the usual penalties and taxes that come with it.
Hardship Withdrawals
If you have an “immediate and heavy” financial need, you might get approved for a penalty-free withdrawal. These sorts of hardship withdrawals are not allowed in all plans, and not all hardship situations exclude you from paying early withdrawal penalties. Check with your HR department to see if your circumstance qualifies for penalty-free hardship withdrawals.
For the next six months, you won’t be able to make any elective contributions to your 401(k), which could put a damper on your short-term retirement savings plans. Hardship withdrawals, on the other hand, are as risky as 401(k) early withdrawals.
401(k) Early Withdrawals Risks
While the 10 percent early withdrawal penalty is the most obvious disadvantage of withdrawing from your account early, you might also encounter other challenges as a result of your pre-retirement payout. The biggest concern, says Stiger, is the loss of compounding returns:
He says that you lose the chance to gain from tax-exempt or tax-deferred compounding. When you take money out too soon, you lose out on the compounding’s power, which is when your earnings build up over time to produce even more gains.
Compounding loss is, of course, a long-term consequence that maybe you won’t see until you approach retirement. Your existing tax burden may be a more immediate risk, as your payout will almost certainly be included in your taxable income.
If your distribution puts you in a higher tax bracket, you will not only pay more for the distribution, but it will affect taxes on your regular income, too. Consult your certified public accountant (CPA) or tax preparer to determine how much you can take without entering a higher tax bracket.
The most straightforward method to prevent these risks is to not even take an early 401(k) withdrawal to begin with. If you really have to make an early withdrawal, make sure you only take out what you need and plan how to top up your account again eventually. That can help you reduce the amount of money you lose in compound returns over time.
When to Make a 401(k) Early Withdrawal?
Financial advisors frequently recommend that an early withdrawal from your 401(k) is a final resort because of the 10% penalty. Due to the availability of penalty-free withdrawals for a variety of financial problems and scenarios, plan participants who take an early withdrawal with a penalty are frequently in dire financial situations.
Stiger says he has witnessed people make withdrawals for a variety of reasons. Everything from a child’s tuition to a spouse’s burial fees; the aim is that payouts will be used for greater, more unexpected needs like medical emergencies, avoiding a home being foreclosed or evicted, and putting food on the table during a down period.
Finally, if you can take advantage of a penalty-free exception, taking an early withdrawal can make sense. It might be the Rule of 55 or the SEPP exemption, or you might be able to take advantage of a recent rule change, such as the Covid-related modifications made available in 2020 as part of the CARES Act.
Before accessing your tax-deferred retirement account early, it’s a good idea to exhaust other options first. Remember that if you’re in a pinch, you can withdraw your Roth IRA contributions without penalty.
Contact Information:
Email: [email protected]
Phone: 8139269909
Bio:
For over 30-years Flavio “Joe” Carreno of The Retirement Advantage has been a Federal Employee Retirement System specialist (FERS) as well as a Florida Retirement System specialist (FRS) independent advocate. An affiliate of PSRE (Public Sector Retirement Educators), a Federal Contractor & Registered Vendor to the Federal Government, also an affiliate of TSP Withdrawal Consultants. We will help you understand your FERS & FRS Benefits, TSP & Florida D.R.O.P. withdrawal options in detail while recognizing & maximizing all concurrent alternatives available.Our primary goal is to guide you into retirement with no regrets; safe, predictable, stable, for life. We look forward to visiting with you.
Disclosure:
Not affiliated with the U.S. Federal Government, the State of Florida, or any government agency. The firm is not engaged in the practice of law or accounting. Always consult an attorney or tax professional regarding your specific legal or tax situation. Although we make great efforts to ensure the accuracy of the information contained herein we cannot guarantee all information is correct. Any comments regarding guarantees, safe and secure investments & guaranteed income streams or similar refer only to fixed insurance and annuity products. Fixed insurance and annuity product guarantees are subject to the claimsâ€paying ability of the issuing company. Annuities are long-term products of the insurance industry designed for retirement income. They contain some limitations, including possible withdrawal charges and a market value adjustment that could affect contract values. Annuities are not FDIC insured.
