401(k)s are incentivized plans to help Americans save for retirement. The government provides tax breaks to encourage you to contribute, but it also enforces certain rules to discourage you from taking distributions before retirement. In some cases, breaking those rules and taking distributions early can cost you a 10% penalty in addition to the ordinary income taxes you'll owe on withdrawn funds.
Let's look at all the approved ways you can take money out of a 401(k) and look into the penalties you'll incur if your early distributions don't fall within one of those exceptions.
How to take money out of your 401(k)
There are many different ways to take money out of a 401(k), including:
- Withdrawing money when you retire: These are withdrawals made after age 59 1/2.
- Making an early withdrawal: These are withdrawals made prior to age 59 1/2. You may be subject to a 10% penalty unless your situation qualifies as an exception.
- Making a hardship withdrawal: These are early withdrawals made because of immediate financial need. You may be still be penalized for them.
- Taking out a 401(k) loan: You can borrow against your 401(k) and will not incur penalties as long as you repay the loan on schedule.
- Rolling over a 401(k): If you leave your job, you can move your 401(k) into another 401(k) or IRA without penalty as long as the funds are moved over within 60 days of your distribution.
- Taking a coronavirus-related withdrawal: There are special rules in place in 2020 allowing a penalty-free withdrawal of up to $100,000 if you're experiencing hardships related to the coronavirus.
Withdrawing when you retire
After you reach the age of 59 1/2, you may begin taking withdrawals from your 401(k). If you leave your job in the calendar year when you turn 55 or later, you can also begin taking penalty-free withdrawals from the 401(k) you had with that current company. If you are a public safety worker, this rule takes effect at the age of 50.
Once you reach 72, you are actually obligated to begin making required minimum distributions or RMDs.
Any withdrawal you make prior to age 59 1/2 is considered an early withdrawal. In most cases you are subject to a 10% penalty for any early withdrawal, in addition to the ordinary income taxes you always owe when taking money out of a 401(k). However, there are a few exceptions:
- Rule of 55: This applies if you leave your current employer in the calendar year you turn 55 or later and take money from that company's 401(k) only.
- Substantially equal periodic payments: These require you to withdraw a certain amount from your account for at least five years or until you reach 59 1/2 (whichever is later).
- Permanent disability: This applies if you meet your employer plan's definition of "disabled."
- Qualifying medical expenses: If your expenses exceed a certain percentage of your adjusted gross income, you can withdraw funds penalty-free to cover them.
- Qualified domestic relations order: If a court orders you to give 401(k) funds to a spouse or dependent, you can withdraw the money penalty-free.
Some 401(k) plans allow you to take early withdrawals when you experience an "immediate and heavy" financial need. Some examples include:
- Medical expenses
- Costs associated with purchasing a primary home
- Tuition payments or other qualifying educational expenses for the 401(k) owner, his or her spouse, or dependents
- Payments necessary to prevent eviction or foreclosure
- Burial or funeral expenses for a parent, spouse, child, or other dependent
Even if your employer's plan permits hardship withdrawals, you may still be subject to the 10% early withdrawal penalty unless you fall within one of the above exemptions.
Some plans allow you to borrow up to 50% of your vested account balance to a maximum of $50,000 within a 12-month period. In 2020, the CARES Act allows employers to bump up those restrictions, allowing savers to withdraw 100% of their vested balance up to a maximum of $100,000. Check with your plan provider if this loan expansion has been made available to you.
A 401(k) loan operates much like a standard loan -- you will have to pay back the borrowed funds with interest. If you default on repayment, it will be considered a distribution, and you could be subject to the 10% penalty for early withdrawals.
As an extension to the standard loans offered for a 401(k), the CARES Act in 2020 permits you a penalty-free withdrawal of 100% of your vested 401(k) account balance up to a maximum of $100,000 if your distribution is coronavirus-related.
You will have up to three years from the time of the withdrawal to pay the ordinary income tax due on withdrawn funds. If you are able, you may also repay the full amount borrowed within three years and therefore incur no income taxes; for any income taxes already filed within those three years, you may submit amended returns for a refund.
Rolling over a 401(k)
If you leave your job or your plan terminates, you can roll over the 401(k) funds to another tax-advantaged retirement account.
You may be able to do a direct rollover, which means the money moves from your 401(k) right into your new tax-advantaged account. You can also do an indirect rollover, in which you receive the funds directly and deposit them in your new account within 60 days to avoid treatment as a distribution.
When you leave a job
When you leave a job, you generally have the option to:
- Leave your 401(k) with your current employer
- Roll over the funds to an IRA
- Roll over the funds to your new employer's 401(k).
If you choose any of those options, you will not owe taxes or a 10% penalty. You can also take this money as a distribution, but this will trigger early-withdrawal penalties if you are under 59 1/2 (unless the Rule of 55 applies).
Rollover to an IRA
Rolling a 401(k) over into an IRA is often a good option when you leave your job or your plan terminates. You can open an IRA with any brokerage and generally have a wider choice of investment options. You may have the option of a direct or indirect rollover.
You must roll over a traditional 401(k) to a traditional IRA to avoid owing taxes. If you wish to instead do a Roth conversion, there will be tax consequences.