A 401(k) plan aims to provide you with retirement income. So the money you sock away in that retirement plan should ideally remain untouched until your golden years. But if you need that money sooner, and your savings aren't enough, you might be tempted to take a 401(k) withdrawal instead. Unfortunately, early 401(k) withdrawals can invite substantial penalties. Let's review how to make 401(k) withdrawals without losing any of your money.

How 401(k) plans work

A 401(k) plan is an employer-sponsored retirement plan that allows workers to set aside funds for the future. There are two kinds of 401(k) plans: traditional and Roth.

With a traditional 401(k), you save on taxes now, but pay taxes later. The money you contribute to a traditional 401(k) gets subtracted from your taxable income, and then gets to grow tax-deferred. So if you contribute $5,000 to a 401(k) this year, and your effective tax rate is 25%, you'll pay $1,250 less in taxes. In addition, as you invest in your 401(k) and your money grows, you're not required to pay taxes on those investment gains each year. You only pay taxes when you eventually withdraw money from your account in retirement.

Man holding piece of paper reading 401K

IMAGE SOURCE: GETTY IMAGES.

What is a Roth 401(k)?

With a Roth 401(k), you pay taxes now but save on taxes later. Your Roth 401(k) contributions don't lower the amount you're taxed on, so you don't get an immediate tax break. But that money still gets to grow tax-free in your account, and when you withdraw money from your plan during retirement, you pay no taxes on it. 

Penalties on early 401(k) withdrawals

To encourage savers not to remove funds from their 401(k) plans prematurely, the IRS will charge a 10% early withdrawal penalty for 401(k) distributions taken before age 59 1/2, unless you qualify for an exception. That means if you remove $20,000 early, you lose $2,000 right off the bat.

And that penalty doesn't account for taxes you might also pay on your withdrawal. Remember, though Roth 401(k) withdrawals are tax-free, traditional 401(k) withdrawals are not. If you remove $20,000 from a traditional 401(k) before age 59 1/2, and your effective tax rate is 25%, you'll pay $5,000 in taxes in addition to that $2,000 early withdrawal penalty.

How to make 401(k) withdrawals without penalties 

Clearly, a 10% early withdrawal penalty can hurt you financially, costing you money you can't necessarily afford to part with. That's why it's a good idea to avoid early withdrawals at all costs. That said, sometimes we're left with no choice but to remove funds from a 401(k) before age 59 1/2. In many cases, you'll have to eat that penalty, but you might qualify for a few exceptions:

  • Medical expenses. Medical expenses are a huge burden for Americans of all ages, so much so that medical debt is the nation's No. 1 source of personal bankruptcy filings. If you're drowning in medical bills, you can take an early 401(k) withdrawal to cover them and avoid penalties, provided your total unreimbursed healthcare expenses exceed 10% of your adjusted gross income (AGI).
  • Permanent disability. If you become permanently disabled, you're allowed to take early 401(k) withdrawals without being penalized.
  • Court-ordered withdrawals. If a court mandates that you pay a portion of your 401(k) to a former spouse or a dependent, you won't be charged a penalty on that withdrawal.
  • Military withdrawals. Qualified military reservists called to active duty for 180 days or more can make early withdrawals penalty-free during that service period.
  • Rollovers to other retirement accounts. If you leave a job that's been sponsoring your 401(k), you might prefer to roll over your 401(k) into another retirement plan, rather than leave it where it is. If that's the case, you can withdraw your 401(k) funds penalty-free, provided you roll all of that money into another qualified retirement plan -- either your new employer's 401(k) or an IRA -- within 60 days. Incidentally, you're welcome to use that money for personal reasons during that 60-day period, as long as you can replace it in full when you fund your new account.
  • Separating from your employer at age 55 or older, aka The Rule of 55. If you leave or are fired from the company sponsoring your 401(k) plan at age 55 or older, you're allowed to cash out that account in the form of a lump sum withdrawal without incurring penalties. You can't, however, leave that same job at 54, wait a year, and then start taking those withdrawals penalty-free -- the rule doesn't work like that.
  • Substantially equal periodic payments. Some folks are fortunate enough to retire early -- say, in their early 50s. If you're able to leave the workforce well ahead of your peers, you might manage to access your 401(k) funds without penalty by taking what are known as substantially equal periodic payments, thanks to Internal Revenue Code Section 72(t). Essentially, you'll need to withdraw money from your 401(k) at least once a year for a minimum of five years, or until you reach age 59 1/2, whichever is longer. For example, if you start taking those withdrawals at least once a year at age 51, you'll need to continue doing so for 8 1/2 additional years. And if you start taking those withdrawals at age 58, you'll need to continue doing so until age 63. 

    The IRS allows you to use one of three different methods to calculate your substantially equal periodic payments.:

    1. The RMD method. (We'll talk about RMDs in a bit.) This method lets you use IRS life expectancy tables to figure out how long you're expected to live and then divide your account balance by that amount. This method is generally the easiest, but it might give you the smallest yearly distribution.

    2. The fixed amortization method. With this method, you draw down your account value over the course of your life expectancy after applying an IRS-approved interest rate to your account's balance. That gives you the same payment year after year.

    3. The fixed annuitization method. This method uses an annuity factor from an IRS mortality table, combined with an IRS-approved interest rate, to produce a distribution that, as with the previous method, will be the same year after year.

Keep in mind that if you're saving in an IRA, you're allowed to take penalty-free early withdrawals to pay for higher education or a first-time home, provided that sum doesn't exceed $10,000. These exceptions, however, don't apply to 401(k)s.

401(k) hardship withdrawals

Some 401(k) plans allow savers to access funds before age 59 1/2 to fulfill an immediate and significant financial need. It's known as a hardship withdrawal, and it applies when you need money to:

  • Cover medical bills.
  • Buy a primary residence.
  • Pay for tuition or educational expenses.
  • Prevent being foreclosed upon.
  • Cover funeral expenses.
  • Make necessary home repairs.

Keep in mind that not all 401(k) plans allow for hardship withdrawals, and that early withdrawal penalties might still apply under some circumstances. For example, your plan might allow you to take a penalty-free hardship withdrawal for medical expenses, but not for the purpose of buying a home or paying for educational expenses. Furthermore, to qualify for a 401(k) hardship withdrawal, you must have no other available resources to cover the expense you're basing your withdrawal on. Again, each plan has its own criteria for proving you need that money, and that your 401(k) is the only way to get it.

Once you take your hardship withdrawal, you'll generally be barred from contributing to your 401(k) for at least six months. That hardship withdrawal will also be limited to the principal funds you've contributed to your 401(k). For example, if you put in $20,000 of your own money, which has since grown to $25,000, you can only take a hardship withdrawal from the $20,000 you put in. And you'll still have to pay taxes on funds withdrawn from a traditional 401(k).

Required minimum distributions

Avoiding penalties related to 401(k) withdrawals is a good thing. So far, we've been talking about evading penalties for removing funds early. But waiting too long to take 401(k) withdrawals could also leave you stuck with penalties.

Whether you house your savings in a traditional 401(k), a 403(b) plan or a Roth 401(k), you must eventually start taking required minimum distributions (RMDs). Because funds in either type of 401(k) get to grow in a tax-advantaged fashion even in retirement, the IRS doesn't want you to get that benefit forever, nor does it want 401(k) funds to serve as inheritances for future generations. It therefore mandates that at least a portion of your account balance be removed year after year so that, ideally, you're depleting your 401(k) in your lifetime. 

Your first RMD is due by April 1 of the year after the year in which you turn 70 1/2. That might sound confusing, but basically, if you turn 70 in May 2019, and turn 70 1/2 in November 2019, you must take your first RMD by April 1, 2020. From that point on, you'll need to take all subsequent RMDs by Dec. 31 of each year.

The exact amount of your RMD will depend on your account balance and life expectancy at the time; online RMD calculators can help you figure that out. The bad news, however, is that if you neglect to take your RMD on time or in full, you'll face a 50% penalty on whatever amount you fail to remove. That means if your RMD for a given year is $10,000, and you don't take any of it, you'll lose $5,000, just like that.

That said, there is an exception to this rule. If you're still working for the company sponsoring your 401(k) when you turn 70 1/2, and you don't own 5% or more of that company, you can hold off on taking RMDs for as long as you remain employed by that company, and you won't have to worry about that dreaded 50% penalty. Once you leave that job, however, the same RMD rules that apply to everyone else will apply to you.

Keep in mind that if you've been saving in a traditional 401(k), you'll need to pay taxes on your RMD. This is not a penalty -- it's simply a function of how traditional 401(k)s work.

401(k) withdrawals versus 401(k) loans

When you're desperate for money, an early 401(k) withdrawal might seem like a reasonable solution. But before you remove funds early, see whether you qualify for a 401(k) loan instead. Some 401(k)s offer this option, and if you're not sure yours does, you can talk to your plan administrator to find out.

As the name implies, a 401(k) loan allows you to borrow money against your retirement plan balance. Generally, you can borrow up to $50,000 or 50% of the amount you have vested in your plan – whichever is less. Some plans will allow you to borrow up to $10,000, even if that's well above that 50% threshold. But you'll still be required to pay interest on that loan, and you'll generally need to repay the entire sum you borrow within five years. Since you're technically paying yourself that interest, that's not such a bad deal, but if you borrow a large sum, you might struggle to repay it on time.

And if you aren't able to repay that 401(k) loan in time, it will be treated as an early withdrawal, which means you'll be subject to the 10% penalty you may have been trying to avoid in the first place. Furthermore, if you lose your job, you'll usually have a mere 90 days to repay your 401(k) loan balance before that 10% penalty kicks in.

Another thing to keep in mind is that many 401(k) plans won't allow you to make additional contributions until you've repaid your loan. They assume that if you have money to fund your account, you should first use it to replace the money you removed.

If your 401(k) is your only available source of money, you're generally better off removing funds with a loan than taking an early withdrawal and getting penalized for it off the bat. You might take out a 401(k) loan if you know your need for money is truly temporary, and you don't anticipate problems paying that sum back quickly.

For example, if you encounter a $5,000 home repair you don't have the money for, but you know you're going to be getting a bonus that will put $5,000 back in your pocket in three months, you might borrow from your 401(k) rather than charge that expense on a credit card and pay interest for 90 days. Either way, if you take out a 401(k) loan, be sure to review its terms carefully, lest you wind up with any unpleasant surprises.

Avoiding early 401(k) withdrawals

When you're stuck in a situation that demands money, taking an early 401(k) withdrawal might seem like a solid bet. But penalties aside, removing funds early from a 401(k) is almost never a good idea. The more money you withdraw before retirement, the less you'll have available in retirement, when you really need it.

Imagine you take an early $20,000 withdrawal from your 401(k) to cover medical bills. That's hardly a frivolous reason. At the same time, that's $20,000 you won't have access to as a senior, when your options for earning more money might be limited.

Furthermore, when you take an early withdrawal from your 401(k), you don't just lose that initial lump sum; you also lose all the growth that money could've achieved. Imagine you earn an average 7% annual return on your 401(k) -- which, incidentally, is more than feasible when you invest heavily in stocks. Let's also imagine that you take a $20,000 withdrawal at age 40 and retire at age 70. In that case, you're not just depriving yourself of $20,000 during your senior years; you're actually losing out on $152,000 when you factor in lost investment growth. And that sort of sum could make a huge difference in your financial picture during retirement.

That's why it really pays to explore alternatives to early 401(k) withdrawals before going that route. If you have a great credit score, you might try applying for a personal loan, and seeing whether you qualify for one with a relatively low interest rate. Or you might try getting a side job to drum up the extra cash you need.

Another option you might consider is liquidating other assets, like stocks held in a traditional brokerage account. You might even consider selling your home and using the proceeds of that sale to cover whatever financial need you're looking at.

Finally, as already stated, though 401(k) loans have their drawbacks, they're generally preferable to taking an early withdrawal. This way, you don't get penalized from the get-go for removing funds from your account.

The right time to take 401(k) withdrawals

Once you turn 59 1/2, you can feel free to start removing funds from your 401(k) without worrying about penalties. Of course, if you're still working at that time, it pays to leave your money alone, so that it can continue to benefit from tax-deferred or tax-free growth, depending on whether you have a traditional 401(k) or a Roth. But if you're at least 59 1/2 and are entering retirement, you shouldn't hesitate to withdraw funds from your 401(k) to cover your living expenses or whatever financial needs you have. After all, that's really what that money is there for.