If you have a 401(k) from your current or former employer and are tempted to take some cash out of it to cover expenses, tread carefully. Unless your withdrawal meets strict requirements, the money you withdraw could be subject to a 10% early withdrawal penalty from the IRS -- in addition to the income tax you'll have to pay on the money you take out.
If you're in a high tax bracket, you could end up paying 50% or more of your withdrawal amount in taxes and penalties. And, while taxes aren't avoidable unless you have a Roth 401(k) (more on that here), there are some instances in which you could avoid paying the 401(k) early withdrawal penalty.
- Wait until you're 59 1/2 years old -- This is the most obvious way, but it's worth mentioning. The universal age for withdrawing money from retirement plans (401(k)s, IRAs, etc.) is 59 1/2 years old.
- Separation from service -- You can begin to withdraw money without the 401(k) withdrawal penalty if you separate from service (read: stop working) in the year in which you'll turn 55 or later. This age requirement is lowered to 50 for public safety employees, such as policemen and firefighters.
- You agree to take equal payments over time -- If you start to take distributions early, but in a series of "substantially equal payments," you can begin to withdraw penalty-free at any time after you stop working. Payments must be spread over at least five years, or until you reach 59 1/2, whichever is longer. For example, if you're lucky enough to retire at age 52, you are allowed to initiate a series of withdrawals from your 401(k), provided that the payments are equal and that they are spread over at least 7.5 years.
- Divorce settlement -- If a domestic relations order assigns a portion of your 401(k) assets with your former spouse, that withdrawal is penalty-free.
- Paying qualified medical expenses -- If your unreimbursed medical expenses during the year are greater than 10% of your adjusted gross income (AGI), you can use your 401(k) assets to pay them without an early withdrawal penalty.
- You become permanently disabled -- While not the most pleasant topic to think about, if you happen to become permanently disabled, the IRS allows you to tap into your 401(k) without penalty, regardless of age.
- Unpaid taxes -- Since a 401(k) early withdrawal penalty goes to the IRS anyway, they are nice enough to waive the penalty if you withdraw from your account to cover unpaid taxes.
- If you contributed too much -- If you or your employer exceeded the maximum 401(k) contribution limit for the year, money can be withdrawn to rectify the problem as long as certain conditions are met.
- You're a "qualified reservist" -- Reservists who are called to active duty for at least 180 days may be eligible for a penalty-free 401(k) withdrawal.
- You roll over the money -- If you withdraw money from your 401(k) and contribute the same amount to another qualified retirement plan (like an IRA) within 60 days, you can avoid the early withdrawal penalty. In fact, this can be an effective way to get an interest-free loan if you need the money for a short time period.
One final thought
Keep in mind that just because you qualify for a penalty-free early 401(k) withdrawal doesn't mean it's necessarily a good idea. In fact, by doing so, you're essentially stealing money from your future self.
For example, let's say you're 35 years old and have $10,000 sitting in a 401(k) from a previous employer. And, we'll assume that you qualify for a penalty-free withdrawal for medical expenses. If you're in the 25% tax bracket, you'll get $7,500 to use for your expenses.
However, if you choose to pay for your medical bills through other means and leave your 401(k) alone until you retire at 65, your account balance could grow to more than $76,000 -- and that's assuming a historically modest 7% average annual return. So, you could have $7,500 now, or more than 10 times that amount when you retire -- seems like a no-brainer to me.
The bottom line is that there are several ways to withdraw from your 401(k) without getting hit with the penalty, but your 401(k) should be used as a last resort until you retire.