Risks Of 401 Early Withdrawals
While the 10% early withdrawal penalty is the clearest pitfall of accessing your account early, there are other issues you may face because of your pre-retirement disbursement. According to Stiger, the greatest of these issues is the hit to your compounding returns:
You lose the opportunity to benefit from tax-deferred or tax-exempt compounding, says Stiger. When you withdraw funds early, you miss out on the power of compounding, which is when your earnings accumulate to generate even more earnings over time.
Of course, the loss of compounding is a long-term effect that you may not feel until you get closer to retirement. A more immediate risk may be your current tax burden since your distribution will likely be considered part of your taxable income.
If your distribution bumps you into a higher tax bracket, that means you will not only be paying more for the distribution itself, but taxes on your regular income will also be affected. Consulting with your certified public accountant or tax preparer can help you figure out how much to take without pushing you into a higher tax bracket.
The easiest way to avoid these risks is to resist the temptation to take an early 401 withdrawal in the first place. If you absolutely must take an early distribution, make sure you withdraw no more than you absolutely need, and make a plan to replenish your account over time. This can help you minimize the loss of your compound returns over time.
What If You Only Need The Money Short Term
Although there are other qualifying exceptions to withdraw IRA or 401k assets penalty-free, those listed above are the major ones. But suppose youre not interested in paying any taxes at all. You can still use your 401k to borrow money via a loan. The interest goes to you, the loan isnt taxable, and it wouldnt show up on your credit report. Heres how it works.
Where Should You Transfer Your 401
You have several options on what to do with your 401 savings after retirement or when you change jobs. For example, you can:
The right choice depends on your needs, and thats a choice everybody needs to make after evaluating all of the options.
Want help finding the right place for your retirement savings? Thats exactly what I do. As a fee-only fidicuary advisor, I can provide advice whether you prefer to pay a flat fee or youd like me to handle investment management for you, and I dont earn any commissions. To help with that decision, learn more about me or take a look at the Pricing page to see if it makes sense to talk. Theres no obligation to chat.
Important:The different rules that apply to 401 and IRA accounts are confusing. Discuss any transfers with a professional advisor before you make any decisions. This article is not tax advice, and you need to verify details with a CPA and your employers plan administrator. Likewise, only an attorney authorized to work in your state can provide guidance on legal matters. Approach Financial, Inc. does not provide tax or legal services. This information might not be applicable to your situation, it may be out of date, and it may contain errors and omissions.
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Your Retirement Money Is Safe From Creditors
Did you know that money saved in a retirement account is safe from creditors? If you are sued by debt collectors or declare bankruptcy, your 401k and IRAs cannot be liquidated by creditors to satisfy bills you owe. If youre having problems managing your debt, its better to seek alternatives other than an early withdrawal, which will also come with a high penalty.
Remember Required Minimum Distributions
While you don’t need to start taking distributions from your 401 the minute you stop working, you must begin taking required minimum distributions by April 1 following the year you turn 72. Some employer-sponsored plans may allow you to defer distributions until April 1 of the year after you retire, if you retire after age 72, but it is not common. Keep in mind that this exception does not apply to plans you may have with previous employers that you no longer work for.
If you wait until you are required to take your RMDs, you must begin withdrawing regular, periodic distributions calculated based on your life expectancy and account balance. While you may withdraw more in any given year, you cannot withdraw less than your RMD.
The age for RMDs used to be 70½, but following the passage of the Setting Every Community Up For Retirement Enhancement Act in Dec. 2019, it was raised to 72.
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Roll Money Into An Ira
If you are not satisfied with the 401 investment options, you can rollover the money into an IRA since the latter has more investment options and offers greater control. You can reallocate your portfolio of investments to help you grow your investments further in years to come.
If you have a string of old 401s when you retire, you should consolidate them into an IRA for better management of your retirement savings. Also, you can reduce the administration fees of your retirement money, and even qualify for discounts on sales charges.
How 401 Hardship Withdrawals Work
A hardship withdrawal is an emergency removal of funds from a retirement plan, sought in response to what the IRS terms “an immediate and heavy financial need.” It’s actually up to the individual plan administrator whether to allow such withdrawals or not. Manythough not allmajor employers do this, provided that employees meet specific guidelines and present evidence of the hardship to them.
According to IRS rules, a hardship withdrawal lets you pull money out of the account without paying the usual 10% early withdrawal penalty charged to individuals under age 59½. The table below summarizes when you owe a penalty and when you do not:
A 401 hardship withdrawal isn’t the same as a 401 loan, mind you. There are a number of differences, the most notable one being that hardship withdrawals usually do not allow money to be paid back into the account. You will be able to keep contributing new funds to the account, however.
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Drawbacks To 401 Loans
Assuming the loan and repayment process goes perfectly smoothly, there are several major reasons you should think twice before borrowing from your 401 fund:
- A 401 loan uses money that should be invested and helping accumulate wealth for your retirement. The funds you pull out of your 401 cannot gain investment value, and the interest payments you’re making to yourself are unlikely to come close to matching the gains you’d make in a moderately successful stock or index fund. contribution or invest elsewhere.)
- For most borrowers, retirement savings get put on hold until the 401 loan is repaid. Payroll deductions for 401 loan repayment typically eliminate or greatly reduce 401 payments for the five years it takes to pay off the loan. Losing five or so years of retirement savings, and likely forfeiting some or all of your employer’s matching contributions to your 401 in the process, is potentially a huge setback in your retirement savings process. The goal with 401 plans, as with all long-term savings programs, is to stash funds in small, steady amounts over long periods of time, and let money accumulate through the power of compound growth and reinvestment. A 401 loan disrupts that process in a major way, and most funds can never fully recover.
If your 401 loan process doesn’t go smoothly, you could face even worse consequences:
What You Should Know About Withdrawing Retirement Funds Early
Is your retirement money only for retirement? Ideally, yes. But its your money, so the decision of what to do with is ultimately yours. During financially challenging times, its easy to understand the temptation to tap into retirement funds earlier than planned. But heres what you should know before you consider accessing retirement savings early.
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Series Of Substantially Equal Payments
If none of the above exceptions fit your individual circumstances, you can begin taking distributions from your IRA or 401k without penalty at any age before 59 ½ by taking a 72t early distribution. It is named for the tax code which describes it and allows you to take a series of specified payments every year. The amount of these payments is based on a calculation involving your current age and the size of your retirement account. Visit the IRS website for more details.
The catch is that once you start, you have to continue taking the periodic payments for five years, or until you reach age 59 ½, whichever is longer. Also, you will not be allowed to take more or less than the calculated distribution, even if you no longer need the money. So be careful with this one!
Youll Be Faced With The Burden Of Replacing Your Retirement Savings
As mentioned earlier, your 401 is intended as a retirement savings vehicle. Typically, when the IRS earmarks a certain account for a certain purpose, youll get the best results when you use the account as intended. Yes, you can access 401 money early, and youll certainly pay for the privilege, but youll also get a far better result if you view your 401 money as a way to cover costs in retirement.
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Rollover To Another Retirement Plan
If you’re withdrawing money from your 401 with the intent to move it to another qualified retirement plan, such as a 401 at a new job or a traditional individual retirement account, a transfer, sometimes called a direct rollover, may be your best option. With a transfer, the financial institution holding your 401 funds pays the money straight into your new retirement account, cutting out the middleman and the income tax withholding. And you don’t need to worry about missing the deadline for completing the rollover.
References
Withdrawals After 59 1/2
To encourage retirement saving, the IRS slaps you with a 10 percent penalty if you siphon money from your 401 before reaching 59 1/2, even if you can prove a financial hardship. This is on top of regular income taxes on the withdrawal. While the penalty disappears after 59 1/2, you’ll still be liable for the income taxes. If you have a Roth 401 account, the contributions are made with after-tax dollars. Roth withdrawals are tax-free, as long as you’ve had the account open at least five years.
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The Risks Of A Rollover
Before people roll over their 401 funds to an IRA, however, they should consider the potential consequences. “Consider the costs inside the 401 funds versus the total cost of an IRA,” including advisor fees and commissions, urges Terry Prather, a financial planner in Evansville, Ind.
Prather raises another, noteworthy scenario. A 401 typically requires a spouse to be named as the primary beneficiary of a particular account unless the spouse signs a waiver provided by the plan administrator. An IRA doesn’t require spousal consent to name someone other than the spouse as the primary beneficiary.
“If a participant is planning to remarry soon and wants to name someone other than the new spouse as the beneficiarychildren form a prior marriage, perhapsa direct rollover to an IRA may be desirable,” Prather says.
How Much Tax Do You Pay On 401 Distributions
A withdrawal you make from a 401 after you retire is officially known as a distribution. While youve deferred taxes until now, these distributions are now taxed as regular income. That means you will pay the regular income tax rates on your distributions. You pay taxes only on the money you withdraw. If you withdraw $10,000 from your 401 over the course of the year, you will only pay income taxes on that $10,000. Its possible to withdraw your entire account in one lump sum, though this will likely push you into a higher tax bracket for the year, so its smart to take distributions more gradually.
The good news is that you will only have to pay income tax. Those FICA taxes only apply during your working years. You will have already paid those when you contributed to a 401 so you dont have to pay them when you withdraw money later.
State and local governments may also tax 401 distributions. As with the federal government, your distributions are regular income. The tax you pay depends on the income tax rates in your state. If you live in one of the states with no income tax, then you wont need to pay any income tax on your distributions. So depending on where you live, you may never have to pay state income taxes on your 401 money.
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Early Withdrawal Age Rules Only Apply To The Assets In The 401 Plan Maintained By Your Former Employer
Assets in an IRA have their own rules regarding a penalty-free early withdrawal. In a similar vein, assets that youve rolled over from your 401 to an IRA will generally no longer be eligible for penalty-free early withdrawals unless you qualify for a different exemption . If theres a possibility you may need to tap into the savings in your 401, you may want to hold off on rolling those assets over to an IRA until you turn 59 ½.
The Devil In The Details
Normally, if you were to take money from your retirement plan, you would be subject to a 10% penalty if you’re under age 59½, along with income taxes on the amount you’re withdrawing.
The relief bill gives you the opportunity to pay the taxes over the course of three years. You can also replenish the amount that you pulled from your retirement account over that time.
These distributions may be taken by people who themselves are diagnosed with coronavirus, or whose spouse or dependent has been diagnosed with COVID-19, or who experience adverse financial consequences from being quarantined, laid off or furloughed.
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What Other Options Are There If You Need Cash
- If you have a Roth IRA for five years, you can withdraw your original contributions at any age, free of federal taxes and penalties.
- For education expenses, explore scholarships or student loans. You can borrow for school but not for retirement.
- You can borrow against the value of your home with a home equity loan or home equity line of credit.
Making A Hardship Withdrawal
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The 4% Withdrawal Rule
The 4% rule says that you can withdraw 4% of your savings in the first year, and calculate subsequent yearâs withdrawals on the rate of inflation. This rule is based on the idea that you should withdraw 4% annually, and maintain the financial security in retirement for 30 years. This strategy is preferred because it is simple to compute, and gives retirees a predictable amount of income every year.
For example, if you have $1 million in retirement savings, 4% equals $40,000 in the first year. If the inflation rises by 2.5% in the second year, you should take out an additional 2.5% of the first yearâs withdrawal i.e. $1000. Therefore, the withdrawal for the second year will be $41,000.
Taking Money Out Of A 401 Once You Leave Your Job
If you no longer work for the company that sponsored your 401 plan, first contact your 401 plan administrator or call the number on your 401 plan statement. Ask them how to take money out of the plan.
Since you no longer work there, you cannot borrow your money in the form of a 401 loan or take a hardship withdrawal. You must either take a distribution or roll your 401 over to an IRA.
Any money you take out of your 401 plan will fall into one of the following three categories, each with different tax rules.
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