What To Ask Yourself Before Making A Withdrawal From Your Retirement Account
Retirement may feel like an intangible future event, but hopefully, it will be your reality some day. Before you take any money out, ask yourself an important question:
Do you actually need the money now?
Rather than putting money away, you are actually paying it forward.
If you are relatively early on in your career, you may be single and financially flexible. But your future self may be neither of those things. Pay it forward. Do not allow lifestyle inflation to put your future self in a bind.
Try to think of your retirement savings accounts like a pension. People working towards a pension tend to forget about it until they retire. There is no way they can access it before retirement. While that money is locked up until later in life, it becomes a hugely powerful resource in retirement.
Consider contributing to a Roth IRA, if you qualify for one.
Because contributions to Roth accounts are after tax, you are typically able to withdraw from one with fewer consequences. Some people find the ease of access comforting.
Keep a few factors in mind:
- There are income limits on contributing to a Roth IRA.
- You will still be taxed if you withdraw the funds early or before the account has aged five years.
How To Cash Out Your 401k And What To Consider
Scott Steinberg4-minute readMay 18, 2021
One of the surest ways to create a comfortable retirement for yourself is to begin saving early on in your career. A 401 plan a type of financial contribution plan which allows you to put a percentage of your salary into an account whose investment gains remain tax-free until funds are withdrawn presents one of the most popular vehicles for doing so. Even better, employers will often match the amount of money set aside up to a certain amount, effectively guaranteeing you free income.
However, in the event that access to money is needed, especially in the wake of a large or unexpected expense, its not uncommon to wonder how to cash out your 401 as well. Here, well take a closer look at the process of cashing out a 401 early, how long it takes to get access to money, and the pros and cons of doing so, including how much early withdrawal before retirement may cost you.
How To Not Run Out Of 401 Money
One of the biggest concerns about retirement is running out of money. This is especially true for those who rely on a 401 for their retirement income. However, you can do a few things to ensure you dont run out of money in retirement.
- First, calculate how much income you will need to cover your expenses. Then, make sure to account for inflation and rising costs of living.
- Next, create a budget and stick to it. Try to limit your discretionary spending and focus on essential expenses.
- Finally, purchase a fixed indexed annuity with a guaranteed lifetime income rider. This will provide you with a stream of income that you cant outlive .
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Setting A Withdrawal Rate
Aside from the minimum required withdrawal, how much you take out is largely up to you.
The retirement lifestyle you can afford will depend not only on your assets and investment choices, but also on how quickly you draw down your retirement portfolio. The annual percentage that you take out of your portfolio, whether from returns or both returns and principal, is known as your withdrawal rate. Figuring out an appropriate initial withdrawal rate is a key issue in retirement planning and presents many challenges.
Why?
Take out too much too soon, and you might run out of money in your later years. Take out too little, and you might not enjoy your retirement years as much as you could. Your withdrawal rate is especially important in the early years of your retirement, as it will have a lasting impact on how long your savings last.
Calculating The Basic Penalty
Assume you have a 401 plan worth $25,000 through your current employer. If you suddenly need that money for an unforeseen expense, there is no legal reason you cannot simply liquidate the whole account. However, you are required to pay an additional $2,500 at tax time for the privilege of early access. This effectively reduces your withdrawal to $22,500.
There are certain exemptions that you can use to take a penalty-free withdrawal however, you will still owe taxes on that money. These are for immediate and heavy financial needs that constitute a hardship withdrawal. Such a withdrawal can also be made to accommodate the need of a spouse, dependent, or beneficiary. These include:
- Certain medical expenses
- Home-buying expenses for a principal residence
- Up to 12 months worth of tuition and fees
- Expenses to prevent being foreclosed on or evicted
- Burial or funeral expenses
- Certain expenses to repair casualty losses to a principal residence (such as losses from fires, earthquakes, or floods
You likely will not qualify for a hardship withdrawal if you hold other assets that could be drawn from, such as a bank account, brokerage account, or insurance policy, in order to meet your pressing needs.
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What Is A 401 Early Withdrawal
Generally, anyone can make an early withdrawal from 401 plans at any time and for any reason. However, these distributions typically count as taxable income. If you’re under the age of 59½, you typically have to pay a 10% penalty on the amount withdrawn. The IRS does allow some exceptions to the penalty, including:
- Total and permanent disability.
- Unreimbursed medical expenses .
- Employee separated from service at age 55 or older but only from the plan at the job you are leaving.
Some 401 plans allow participants to take hardship distributions while you are still participating in the plan. Each plan sets its own criteria for what constitutes a hardship, but they usually include things like:
- Medical or funeral expenses
- Avoiding eviction or foreclosure
- The cost of repairing damage to the employee’s home
Hardship withdrawals don’t qualify for an exception to the 10% early withdrawal penalty unless the employee is age 59½ or older or qualifies for one of the exceptions listed above.
Withdrawal Rules Frequently Asked Questions
If you participate in a 401 plan, you should understand the rules around separation of service, and the rules for withdrawing money from your account otherwise known as taking a withdrawal. 401 plans have restrictive withdrawal rules that are tied to your age and employment status. If you dont understand your plans rules, or misinterpret them, you can pay unnecessary taxes or miss withdrawal opportunities.
We get a lot of questions about 401 withdrawal rules from participants. Below is a FAQ with answers to the most common questions we receive. If you are a 401 participant, you can use our FAQ to understand when you can take a withdrawal from your account and how to avoid penalties.
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Eligibility For A Hardship Withdrawal
Even if your employer offers the measure, you should be cautious about using it. Financial advisors typically counsel against raiding your retirement savings except as an absolute last resort. Indeed, with new rules now in place that make hardship withdrawals easier, some advisors fear a run on retirement funds at the expense of using options that are less damaging to long-term financial health.
The Internal Revenue Service ‘s immediate and heavy financial need stipulation for a hardship withdrawal applies not only to the employee’s situation. Such a withdrawal can also be made to accommodate the need of a spouse, dependent, or beneficiary.
Immediate and heavy expenses include the following:
- Certain medical expenses
- Home-buying expenses for a principal residence
- Up to 12 months worth of tuition and fees
- Expenses to prevent being foreclosed on or evicted
- Burial or funeral expenses
- Certain expenses to repair casualty losses to a principal residence
You wont qualify for a hardship withdrawal if you have other assets that you could draw on to meet the need or insurance that will cover the need. However, you needn’t necessarily have taken a loan from your plan before you can file for a hardship withdrawal. That requirement was eliminated in the reforms, which were part of the Bipartisan Budget Act passed in 2018.
What Types Of Retirement Plans Require Minimum Distributions
The RMD rules apply to all employer sponsored retirement plans, including
profit-sharing plans, 401 plans, 403 plans, and 457 plans. The RMD rules also apply to traditional IRAs and IRA-based plans such as SEPs, SARSEPs, and SIMPLE IRAs.
The RMD rules also apply to Roth 401 accounts. However, the RMD rules do not apply to Roth IRAs while the owner is alive.
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When You Leave A Job
When you leave a job, you generally have the option to:
- Leave your 401 with your current employer
- Roll over the funds to an IRA
- Roll over the funds to your new employer’s 401.
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 .
Calculating The Total Penalty
In the example above, assume your employer-sponsored 401 includes a vesting schedule that assigns 10% vesting for each year of service after the first full year. If you worked for just four full years, you are only entitled to 30% of your employer’s contributions.
If your 401 balance is composed of equal parts employee and employer funds, you are only entitled to 30% of the $12,500 your employer contributed, or $3,750. This means if you choose to withdraw the full vested balance of your 401 after four years of service, you are only eligible to withdraw $16,250. The IRS then takes its cut, equal to 10% of $16,250 , reducing the effective net value of your withdrawal to $14,625.
If you remove funds from your 401 before you turn age 59 12 , you will get hit with a penalty tax of 10% on top of the taxes you will owe to the IRS.
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Which Is Right For You
For many, 401 loans are a better option than early withdrawals. After all, as long as you pay the money back during the required time period, you won’t have to pay taxes on the amount withdrawn. Plus, the interest you’ll pay is added to your own retirement account balance.
However, there are several reasons to think twice before taking out a 401 loan.
For example, if you left your job in December of 2022 and had a $2,000 outstanding balance on your loan, you would have until to repay $2,000 in full.
- If you’re not able to repay the loan, your employer will treat the unpaid balance as a distribution.
- Typically, it will be considered taxable income and subject to the 10% early withdrawal penalty.
Ideally, you want to leave your 401 alone until retirement. However, if you find yourself in a really tough spot, borrowing from your 401 might be a better option than simply cashing out your balance. Just make sure you understand the potential consequences and do what you can to repay the balance quickly so you can start rebuilding your retirement nest egg.
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Consider Converting Your 401 To An Ira
Individual retirement accounts have slightly different withdrawal rules from 401s. So, you might be able to avoid that 10% 401 early withdrawal penalty by converting your 401 to an IRA first. s and IRAs, of course.) For example:
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Theres no mandatory withholding on IRA withdrawals. That means you might be able to choose to have no income tax withheld and thus get a bigger check now. You still have to pay the tax when you file your return, though. So if youre in a desperate situation, rolling the money into an IRA and then taking the full amount out of the IRA might be a way to get 100% of the distribution. This strategy may be valuable for people in low tax brackets or who know theyre getting refunds.
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Request A Hardship Withdrawal
In certain circumstances you may qualify for whats known as a hardship withdrawal and avoid paying the 10% early distribution tax. While the IRS defines a hardship as an immediate and heavy financial need, your 401 plan will ultimately decide whether you are eligible for a hardship withdrawal and not all plans will offer one. According to the IRS, you may qualify for a hardship withdrawal to pay for the following:
- Medical care for yourself, your spouse, dependents or a beneficiary
- Costs directly related to the purchase of your principal residence
- Tuition, related educational fees and room and board expenses for the next 12 months of postsecondary education for you, your spouse, children, dependents or beneficiary
- Payments necessary to prevent eviction from your principal residence or foreclosure on the mortgage on that home
- Funeral expenses for you, your spouse, children or dependents
- Some expenses to repair damage to your primary residence
Although a hardship withdrawal is exempt from the 10% penalty, income tax is owed on these distributions. The amount withdrawn from a 401 is also limited to what is necessary to satisfy the need. In other words, if you have $5,000 in medical bills to pay, you may not withdraw $30,000 from your 401 and use the difference to buy a boat. You might also be required to prove that you cannot reasonably obtain the funds from another source.
How To Take Money Out Of Your 401
There are many different ways to take money out of a 401, 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 loan: You can borrow against your 401 and will not incur penalties as long as you repay the loan on schedule.
- Rolling over a 401: If you leave your job, you can move your 401 into another 401 or IRA without penalty as long as the funds are moved over within 60 days of your distribution.
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Alternatives To The Rule Of 55
The rule of 55 is not the only way to take penalty-free distributions from a retirement plan. Thereâs another way to take money out of 401, 403, and even IRA retirement accounts if you leave a job before the age of 59 1/2. Itâs known as the Substantially Equal Periodic Payment exemption, or an IRS Section 72 distribution.
A SEPP plan has a twist. You start by estimating your life expectancy. Then use that to calculate five similar size payments from a retirement plan for five years in a row before the age of 59 1/2. Whatâs different is that these distributions can occur at any agetheyâre not bound by the same age threshold as the rule of 55.
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Taxes If You Withdraw Money In Retirement
When you withdraw money from a 401 in retirement, you will owe taxes in the year when you take the distribution. The withdrawals will be taxed as your other sources of income at your tax bracket rate. At the minimum, you will pay federal income taxes on the distribution. If you are a resident of a state that imposes state income taxes on retirement distributions, you will pay extra taxes. However, certain states don’t tax 401 distributions, and you wonât pay additional taxes.
For Roth 401 withdrawals, you wonât pay income taxes when you withdraw money in retirement, since you had already paid income taxes at the onset. You must have reached 59 ½ and have held the account for five years or more to qualify for tax-free withdrawals from your Roth 401.
If you are already 72, you must start taking the required minimum distributions from a traditional 401 and Roth 401. If you do not take the mandatory distributions, you will incur a 10% penalty on the distribution not taken.
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How Is The Amount Of The Required Minimum Distribution Calculated
Generally, a RMD is calculated for each account by dividing the prior December 31 balance of that IRA or retirement plan account by a life expectancy factor that the IRS publishes in Tables in Publication 590-B, Distributions from Individual Retirement Arrangements . Choose the life expectancy table to use based on your situation.
Joint and Last Survivor Table II
How Can I Avoid Paying Taxes On My 401k Withdrawal
How Can I Avoid Paying Taxes on My 401 Withdrawal?
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