A 401(k) is one of the most popular employer-sponsored retirement plans because most full-time employees can participate and because employers can match some of their employees' contributions. It also helps you save on taxes, either by delaying taxes on your 401(k) funds until withdrawal if you have a traditional 401(k) or by enabling you to pay taxes now to get tax-free withdrawals in retirement if you have a Roth 401(k).

Whichever type you have, you need to understand the rules associated with contributing to and withdrawing money from your 401(k) to avoid costly mistakes. Here are the most important rules you should be aware of.

The words 'Know the rules' printed on a small piece of paper pinned to a corkboard

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Withdrawal rules

Because the 401(k) is a tax-advantaged account, the government imposes rules on when and how you can withdraw funds. Here are some of the most important.

Penalty-free withdrawals

You typically cannot withdraw money from a traditional 401(k) before 59 1/2 without paying a 10% early withdrawal penalty (on top of taxes). But there are exceptions for qualifying early withdrawals, discussed below, as well as Roth 401(k) contributions. You can take Roth contributions out penalty-free as long as you've had the account for at least five years, though you can still pay a penalty for accessing your Roth earnings before 59 1/2.

Early withdrawals

Early withdrawals are any 401(k) withdrawals you make before you're 59 1/2. Often they result in a 10% early withdrawal penalty, but there are some exceptions, including:

  • Substantially equal periodic payments (SEPPs): SEPPs require you to withdraw a certain amount annually from your 401(k) for at least five years or until you reach 59 1/2, whichever is later.
  • Rule of 55: If you leave your employer in the year you turn 55 or later, you may take penalty-free withdrawals from the 401(k) you had with that company only. This rule kicks in at 50 for public safety workers like firefighters and police officers.
  • Qualifying medical expenses: If your medical expenses exceed 10% of your adjusted gross income (AGI), you can withdraw money from your 401(k) to cover them penalty-free.
  • Disability: If you become permanently disabled, you can withdraw your 401(k) funds penalty-free before 59 1/2.
  • Domestic relations court order: You can withdraw funds penalty-free if a court orders you to give money to a divorced spouse or dependent under a qualified domestic relations order.
  • 401(k) loan: A 401(k) loan enables you to temporarily withdraw funds from your 401(k) and pay them back over time with interest. If you fail to pay back everything you borrow, the outstanding balance is considered a distribution and taxed accordingly.

Hardship withdrawals

Hardship withdrawals allow you to take out retirement funds to cover an immediate financial need. They are usually subject to the 10% early withdrawal penalty unless you qualify for one of the exceptions listed above. Common reasons for hardship withdrawals include:

  • Medical bills
  • Higher-education expenses
  • Home purchase
  • Avoiding eviction or foreclosure
  • Funeral expenses
  • Repairs related to damage to a primary home

Not all 401(k)s allow hardship withdrawals, so check with your plan administrator to see if this is an option.

Required minimum distributions (RMDs)

RMDs are the minimum amounts you must withdraw from your 401(k) annually beginning at 70 1/2 (if you reached this age before 2020) or 72 (if you will reach this age in 2020 or later). You can calculate yours here by dividing the total balance of your 401(k) by the distribution period next to your age.

You're free to take out more than this annually if you want to, but failure to take out at least this much results in a 50% penalty on the amount you should've withdrawn.

There's an exception to the RMD rule if you're over 70 1/2 or 72 and still working, as long as you own no more than 5% of the company you work for. In that case you can delay RMDs from your 401(k) at your current company, but you must still take RMDs from older 401(k)s.

IRA rollovers

You are free to roll over your 401(k) funds to an IRA at any time, though you may incur a one-time fee for doing this. The simplest way is to request that your 401(k) plan administrator directly transfer the funds to your IRA. You'll have to fill out a form stating where you'd like the funds sent, but then your plan administrator will transfer the funds directly so the government doesn't tax you for an early withdrawal.

You can also do an indirect transfer where you withdraw all the money from your 401(k) and then deposit it into your IRA yourself. As long as you do this within 60 days of the withdrawal, you won't owe any taxes, but if you fail to deposit the full amount in your IRA before the deadline, the government considers it a distribution.

Contribution limits

The government imposes restrictions on how much you can contribute to your 401(k) annually. Employers that offer matching will also have their own rules about how their matching system works and when you get to keep these funds.

Annual contribution limits

You are allowed to contribute up to $19,500 to a 401(k) in 2020 or $26,000 if you're 50 or older; however, these limits may change from year to year. If you exceed the contribution limits, the government will tax the excess funds twice -- once in the year you make the contribution and again in the year you withdraw funds. You can avoid this by withdrawing the excess before the tax deadline.

The government also imposes limits on total contributions to your retirement plan, including employer-matched contributions: $57,000 in 2020 or $63,500 if you're 50 or older. 

Employer matching

Some companies match a portion of their employees' contributions. Dollar-for-dollar matches exist, but they're rare. It's more common to see a company match a percentage of employee contributions, like $0.50 on the dollar. Usually this is capped at a percentage of your income, with 6% being a common limit for a $0.50-on-the-dollar match. Every company has its own matching system, so talk to your plan administrator to learn about yours.

Vesting schedule

Companies that offer an employer match often impose a vesting schedule, which determines when you're allowed to keep your employer-contributed 401(k) funds if you leave the company. Some companies offer immediate vesting, but it's more common to see cliff vesting, whereby you must work for the company for a certain number of years before being allowed to keep any employer-matched funds, or graded vesting, whereby your employer-matched funds are released to you gradually over time. 

Understanding these basic rules about your 401(k) can prevent you from making a mistake that costs you money. Review the rules above before you make a withdrawal or leave your company to avoid paying unnecessary taxes on your distributions.