Tapping your 401(k) early is widely regarded as a cardinal sin in investing. When you take a distribution before age 59 1/2 (or 55 if you've left your job), you'll typically owe a 10% penalty on top of income taxes for the amount you withdraw. Your money also misses out on time in the market, the most valuable force you have in making your money grow.
Ideally, you'd have emergency savings to draw from should the unexpected occur, or you'd be able to turn to a low-interest credit card or loan. But sometimes your 401(k) may be the only source of funds you can turn to. Provided that you've explored every alternative, here are three times when an early 401(k) withdrawal could make sense.
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1. You're facing a dire emergency
If you're facing a crisis -- say you're at risk of foreclosure or eviction, or you need money for medical treatment -- tapping your 401(k) through a hardship withdrawal may make sense if you don't have much savings elsewhere.
But be aware that you'll still owe income taxes plus a 10% penalty in some cases. (One exception: Withdrawals for unreimbursed medical expenses above 7.5% of your adjusted gross income aren't typically subject to the 10% penalty.) In fact, your plan administrator will automatically withhold taxes. According to Fidelity, you'd need to withdraw nearly $24,000 to cover taxes and penalties on a $15,000 withdrawal.
Even in a crisis, a hardship withdrawal may not be your only option. If you're facing foreclosure, ask your lender if they offer forbearance or loan modification programs. Often, you can negotiate a payment plan for large medical bills.
2. You have a total disability
You may be able to avoid the 10% penalty on early 401(k) withdrawals if you have what the IRS calls a "total and permanent disability." Note that this definition has even stricter criteria than the definition for Social Security disability. To meet the definition, you need to have a condition that's either fatal or that will leave you unable to do substantial work indefinitely.
3. You're taking a loan to pay off high-interest debt
If you're overwhelmed by high-interest debt (think 8% or higher), taking out a 401(k) loan could make sense. This is different from a withdrawal, though.
With a 401(k) loan, you can borrow up to the lesser of $50,000 or 50% of your vested balance. You typically have up to five years to pay it back.
But here's where it gets risky: If you leave your job for any reason, you'll have to pay it back by tax day of the following year. In other words, if you left your job on June 30, 2023, you'd owe the balance of your loan by April 15, 2024. Some plans will also prohibit you from making additional contributions if you have an outstanding loan, which could mean missing out on your employer match.
The upside is that you'll avoid the tax bill and the 10% penalty when you take a 401(k) loan. You'll pay interest on the loan, but the good news is, you're paying the interest to yourself.
Some people also use a 401(k) loan to come up with a down payment for a first-time home purchase. But use extreme caution here: Remember that even if you avoid taxes and penalties with a loan, your money is still missing out on time in the market. In this case, building your savings further is often the better bet.
A better alternative to early 401(k) withdrawals
If you have both a 401(k) and a Roth IRA, the Roth IRA is typically the best place to turn in a cash crunch. You can avoid taxes and penalties altogether if you limit your withdrawals to the amount you contributed.
Early retirement account withdrawals should be a last resort. Focus on building an emergency fund, even if you can only afford to budget $25 or $50 per paycheck. Any money you have socked away in a bank account will provide you with a safety cushion so that your retirement account isn't the place you turn in tough times.
