Because the government provides tax savings to incentivize investing for retirement in a 401(k), there are restrictions associated with 401(k) withdrawals. In fact, unless you fall within a permissible exception, you could owe a substantial penalty for early 401(k) withdrawals, which are defined as those made before the age of 59 1/2.
Here's what you need to know about how much withdrawing money from a 401(k) early could cost you.
The cost of early withdrawals from your 401(k)
An early 401(k) withdrawal is a withdrawal of funds from your tax-advantaged 401(k) retirement account that is made before you reach the age of 59 1/2.
If you take an early 401(k) withdrawal, you are normally subject to a 10% penalty on the amount you withdrew from your account. That means taking a $10,000 withdrawal would require you to pay a $1,000 tax penalty to the IRS. This is on top of the tax you always owe on 401(k) withdrawals, as distributions are always taxed as ordinary income.
There are, however, limited exceptions to this extra 10% penalty, including if you take a hardship withdrawal. And the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) has also created a new exemption to permit penalty-free withdrawals in 2020 for those affected financially by COVID-19.
While many people focus on the 10% penalty when considering the expenses associated with an early 401(k) withdrawal -- as it is a major up-front cost you'll have to pay -- you should also evaluate the opportunity cost of withdrawing funds from your account prior to retirement. When you take an early 401(k) withdrawal, the money from your distribution will not remain invested to continue earning returns. As a result, your account balance at retirement will be substantially smaller.
In fact, the Center for Retirement Research at Boston College found average wealth at retirement is around 25% smaller because of "leakage," which includes cash-outs, hardship withdrawals, and loan defaults.
The more you withdraw from your 401(k) and the younger you are when you do it, the more outsize the impact. If you take an early 401(k) withdrawal of $10,000 at the age of 30, your account balance would be almost $107,000 lower at the age of 65 than it would have been had the money remained invested (assuming a 7% average annual return on investment).
COVID-19 401(k) withdrawals
With many Americans facing financial hardship due to COVID-19, the CARES Act established special rules for 401(k) withdrawals applicable in 2020. But those benefits will expire on Dec. 31, 2020.
Under the CARES Act, those experiencing financial hardships related to the coronavirus are permitted to take a penalty-free withdrawal of up to $100,000 or 100% of your vested 401(k) account balance -- whichever is less.
You will still owe ordinary income tax on the withdrawn funds, but not incurring the penalty will take some of the sting out of having to access your retirement money early. The CARES Act also enables you to pay the income tax due on your distribution over three years, while it is customarily due in the year of the withdrawal.
Unfortunately, you will still experience the loss of potential investment gains if you must take a COVID-19-related distribution. However, the CARES Act also gives you three years to repay the withdrawn funds to your 401(k) without affecting eligibility for future contributions. If you repay the money, you will also not be subject to taxes on the repaid withdrawal.
Coronavirus-related hardship distributions are not the only penalty-free distributions that you can make from a 401(k) prior to age 59 1/2.
The IRS also allows for other hardship distributions in circumstances where you, your spouse, or a dependent experience "an immediate and heavy financial need" if the amount you are withdrawing is "necessary to satisfy the financial need."
The examples the IRS provides that might constitute an immediate and heavy need include:
- Certain medical expenses
- Costs associated with purchasing a primary home
- Tuition and educational fees and expenses
- Expenses associated with the repair of damage to a primary home under certain circumstances
- Money necessary to prevent eviction or foreclosure from a primary home
However, you should be aware that your plan administrator may not permit these hardship withdrawals, even if the IRS allows them. And you must not have other sources of funds to cover these expenses in order for the need to be deemed immediate and heavy.
You may also be able to take penalty-free early distributions under certain other circumstances, such as if you become disabled; if you're ordered to pay some of your 401(k) funds to another person, such as in the case of divorce; if you take a series of substantially equal payments for at least five years or until you turn 59 1/2; or if you leave your job in the calendar year you turn 55.
Consider a 401(k) loan
A 401(k) loan is an alternative to withdrawing funds from a 401(k).
Ordinarily, a loan can be a better option than a withdrawal because you do not incur the 10% penalty for early withdrawals. Plus, the money is supposed to be returned to your account, so you won't miss out on decades of potential investment gains. However, if you default on the loan, the early withdrawal penalty may still be assessed, so this is a high-risk option.
In 2020, a 401(k) withdrawal may actually be a better alternative because a defaulted loan is subject to the 10% early withdrawal penalty, while an early withdrawal is not. Because a withdrawal taken this year can be repaid over three years under the CARES Act rules and doesn't present the risk of incurring the 10% penalty, if you become unable to repay the funds, this option may be preferable even if it provides you with less time to put the money back than a 401(k) loan would.
Still, before taking either a 401(k) loan or a 401(k) withdrawal under any circumstances, it is important to consider the financial consequences including any penalties or taxes you may owe, as well as the lost potential return on investment had your funds been left to grow until retirement. Withdrawals and loans should be considered a last resort due to the outsize opportunity costs that lost returns present.