When Should You Make A 401 Early Withdrawal
Considering the 10% penalty, financial planners often advise taking an early withdrawal from your 401 as a last resort. Since penalty-free withdrawals are available for a number of financial hardships and situations, plan participants who take an early withdrawal with a penalty are often in serious financial straits.
Ive seen people take withdrawals for a number of reasons, Stiger says. Everything from a childs tuition to a spouses burial expenses the hope is that distributions are used for larger, more unexpected expenses like medical emergencies, keeping a home out of foreclosure or eviction, and in a down period, putting food on the table.
Ultimately, taking an early withdrawal can make sense if you are able to take advantage of a penalty-free exception, use the Rule of 55 or the SEPP exemption, or take advantage of a topical change in rules, such as the Covid-related changes offered in 2020 as part of the CARES Act.
It might make sense to exhaust other options firstcheck out these 10 ways to get cash nowbefore turning to your tax-deferred retirement account for an early withdrawal. And remember: Contributions to a Roth IRA can always be withdrawn without penalty if youre truly in a bind.
What Is The Rule Of 55
Your 401 account is likely one of the most valuable assets you have, so it’s essential to know when and how you can access it. These accounts are intended to fund your retirement, and as such you can access them penalty-free when you reach age 59½. In most cases, taking money out of your 401 before then will cost you a pretty penny: Early withdrawals come with a 10% penalty.
There are a few exceptions, however, and one of them could help you if you want or need to retire early. The Rule of 55 is an IRS provision that allows you to withdraw funds from your 401 or 403 without a penalty at age 55 or older. Read on to find out how it works.
Tips For Planning Your Retirement
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Who Should Withdraw From Their 401 Early
Just because you qualify for a hardship-related withdrawal doesnt mean you should take one without weighing all your other options.
The experts we spoke with were all in agreement that withdrawing from your 401 shouldnt be your first move. However, they also indicated that if youre truly in need, then you should take advantage of the CARES Acts allowances.
It should be a last resort option. People shouldnt get carried away and start using their 401 assets just because they can, Pfau says.
A Means Of Avoiding High
You may consider finding quick financial relief by putting expenses on a credit card or taking out a loan. Know that both of these options require you to pay back the amount with interest, which could make the amount you owe much greater than you originally needed . Alternatively, withdrawing from retirement accounts in a disaster situation gives you a cushion of three years to pay the amount back, interest-free.
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Hardship Withdrawal May Also Be Barred
Despite the fact that many plan sponsors aren’t allowing CRDs, there are still other ways Americans can access their retirement savings early. Dee persisted, requesting instead a disaster hardship withdrawal. Typically, these types of withdrawals are available if you have suffered a loss of income because you live in an area that the Federal Emergency Management Agency has designated a disaster.
But to get a hardship withdrawal approved, the disaster declaration must include individual assistance. In other words, it’s not enough that the area has been declared a disaster “individual assistance” also must be available. And there’s some debate whether Montana’s coronavirus-related disaster declaration was designated for individual assistance, or just public assistance.
“The Montana governor’s office sent an email stating Montana had been approved for state, public and individual assistance from FEMA,” Dee says. But her husband’s plan provider disagrees. “It’s very frustrating.”Yet Hadley says it appears Montana has not yet been designated for individual assistance, just public assistance. But at the end of the day, “this is, in fact, an idiosyncrasy in the IRS hardship rules,” Hadley says. “The coronavirus pandemic has revealed this quirk.” No one really paid much attention to the nuance until Covid-19 hit, he adds, saying that the IRS only recently changed its rules around hardship withdrawals in the wake of federally declared disasters.
How To Make Withdrawals From Your 401
Regardless of when you do it, making a withdrawal from your 401 involves following a handful of rules. Thats because youre tapping your tax-deferred retirement savings, which means the IRS keeps a close eye on it. During retirement, these withdrawals are also known as distributions. Perhaps the most important age when it comes to 401 withdrawals is 59.5. Thats because withdrawals made before that age come with a steep 10% penalty. For more hands-on guidance with your situation, consider enlisting the help of a financial advisor.
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Medical Expenses Or Insurance
If you incur unreimbursed medical expenses that are greater than 10% of your adjusted gross income in that year, you are able to pay for them out of an IRA without incurring a penalty.
For a 401k withdrawal, if your unreimbursed medical expenses exceed 7.5% of your adjusted gross income for the year then the penalty will likely be waived.
Those Who Truly Need It
It really comes down to need. If you need to withdraw your money, then withdraw your money. Thats really the essence of the CARES Act. It simply makes a need-based withdrawal less harmful. If you dont need to, then dont, says Brandon Renfro, a financial advisor and assistant professor of finance at East Texas Baptist University.
Its important to consider what things will be like after you take a withdrawal and once things are back to a new normal. Under the CARES Act, you have to repay your withdrawal within three years. If you just need a withdrawal to get you through the next few months before you start earning regular paychecks again, it could be a good option.
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Youre Rolling Over Funds
If you leave, quit, or get fired from the company at age 55 or older, you can cash out that account in a lump sum withdrawal without incurring a penalty.
If youre under 55 years of age , you have up to 60 days to rollover your funds to a new 401 or IRA without triggering a taxable event. The best way to accomplish the rollover is to transfer the money directly from the old custodian to the new custodian to avoid having 20% automatically withheld for income tax.
If you fail to put the entire amount into a new retirement account within two months, it will be considered a distribution that is not only taxed but penalized if youre under 59 ½.
Hardships Early Withdrawals And Loans
Generally, a retirement plan can distribute benefits only when certain events occur. Your summary plan description should clearly state when a distribution can be made. The plan document and summary description must also state whether the plan allows hardship distributions, early withdrawals or loans from your plan account.
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You Must Leave Your Job The Year You Turn 55or Later
If you retire or are laid off in the calendar year you turn 55 or lateror the year you turn 50 if youre a public service employeeyou can withdraw funds from your current 403 or 401 plan without paying the early withdrawal 403 or 401 penalty.
You cant retire at age 53 and then start taking 401 withdrawals at age 55, for instance. It only works if youve left your job in the year you turn 55 or later, says Luber. You cant start taking that money out if youve already retired early.
Note: Not all employers may support these early withdrawalsand even if they do, they may require you withdraw all of your money in one lump sum. Check with your retirement plan provider to figure out your plans policies.
If You Left Your Previous Employer Before Age 55
The special age 55 withdrawal provision doesn’t apply if you leave your previous employer before you reach age 55, or age 50 for public safety employees, even if you’re over age 55 now. Any withdrawals you take are subject to the penalty tax unless you can roll your 401 plan to an IRA and qualify for an exception to the penalty.
The date you leave employment with the company is the pivotal factor, not the date at which you begin taking distributions. That date must meet the age-55 rules.
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Rules About Early 401 Withdrawals
Should you make a 401 withdrawal before you reach age 59.5, the IRS will consider it an early distribution. This will induce a 10% tax penalty on it. In addition, because you have yet to pay any taxes on the money, youll owe income taxes. As you can imagine, this is a pretty dangerous way to withdraw funds from your 401.
That said, the IRS allows for penalty-free hardship withdrawals. To qualify for one, youll need to demonstrate what the IRS calls an immediate and heavy need. On top of this, you must prove that there are no other assets that could satisfy that need, such as a vacation home.
Examples of hardships that can earn you an exemption from the 10% withdrawal penalty include:
- Disability
- Housing payments needed to prevent eviction
- Certain home repair expenses for a primary residence
It should be noted, though, that its up to your plan to allow for hardship withdrawals. The IRS doesnt require them. It only delineates the circumstances under which they may happen. Also, you should know that though you wont have to pay the 10% penalty, you will still have to pay income taxes on the distribution.
Who Qualifies To Take A Cares Act 401k Withdrawal
To qualify for the tax penalty exemption:
- The account owner, their spouse, or dependent must have been diagnosed with COVID-19 by a CDC-approved test, or
- The account owner must have experienced adverse financial consequences as a result of COVID-19-related conditions. For example, adverse financial consequences might include a delayed start date for a job, a rescinded job offer, quarantine, lay off, job furlough, reduction in pay or hours, a reduction in self-employment income, the closing of a business, an inability to work due to lack of child care, or other factors.
The IRS explains those qualifications in more detail in Notice 2020-50, Guidance for Coronavirus-Related Distributions and Loans from Retirement Plans Under the CARES Act.
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You Could Withdraw Money From Another Source
Obviously, if you have an emergency fund or other personal savings to draw upon, you should use this before tapping your 401. You might also prefer to withdraw funds from a different type of retirement account, like a Roth IRA, before your 401 if you have one.
Roth retirement accounts are funded with after-tax dollars. That means you pay taxes on your contributions the year you make them, and then you can withdraw your contributions tax-free later. There’s no penalty on contribution withdrawals at any age, but you normally pay taxes and penalties for withdrawing earnings before you’ve had the account for at least five years and before you turn 59 1/2. But the early withdrawal penalty is waived this year, and you can spread your tax liability out over several years, just as you can with a 401.
This could be a better choice than your 401, especially if you just limit yourself to withdrawing your personal contributions. If you do that, you won’t owe taxes at all.
Taking a 401 withdrawal to help you out this year is a personal decision. If you do tap your savings, remember to craft a new retirement plan when you are able to begin saving again so that you can keep yourself on track for a secure future.
Purchasing Your First Home
You can use money from your 401 to buy a house. But you will pay a 10% penalty.
You can take money from your IRA without a penalty. You do not have to be a first-time home buyer, but you cannot buy another house if youve owned a home in the last two years. You can take more than one withdrawal for a home, but there is a $10,000 limit over a lifetime.
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Who Qualifies For Covid
The IRS allows withdrawals for COVID-related 401 hardships if:
- You, your spouse, or a dependent are formally diagnosed by a CDC-approved test.
- Your household suffers a financial setback from quarantine, furlough, a layoff, or reduced hours.
- Lack of child care due to COVID-19 causes adverse financial consequences.
- The business you own or operate had to reduce hours, limit capacity, or close because of the virus.
How To Avoid The Early Withdrawal Penalty
There are a few exceptions to the age 59½ minimum. The IRS offers penalty-free withdrawals under special circumstances related to death, disability, medical expenses, child support, spousal support and military active duty, says Bryan Stiger, CFP, a financial advisor at Betterments 401.
If you dont meet any of those qualifications, you arent entirely out of luck, though. Youve got a couple of options that may let you make penalty-free withdrawals, if youre slightly younger than retirement age or plan your withdrawals methodically.
If youre between age 55 and 59 ½ and you lose your job, the IRS will allow you to withdraw from your 401 plan penalty-free. This is called the Rule of 55, and it applies to everyone within this age group who loses a job, no matter whether youre fired, laid off or voluntarily quit. Stiger says. To qualify for the Rule of 55, the 401 you hope to take withdrawals from must be at the company youve just parted ways with. Note that the Rule of 55 does not apply to IRAs.
There is also the Substantially Equal Periodic Payment exemption, or an IRS Section 72 distribution, say Stiger. With SEPP you can take substantially equal payments from your 401 based on life expectancy. Unlike the Rule of 55, you may use SEPPs to tap an IRA early.
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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.
When Can You Withdraw From Your 401 Or Ira Penalty
Editor’s Note: This story originally appeared on Personal Capital.
401 plans, IRAs and other tax-advantaged retirement savings accounts are common ways to save for retirement, and millions of Americans pour money into them every year.
Its generally wise to avoid withdrawing money from your 401, as there are often hefty penalties and taxes to consider for early withdrawals.
Sometimes, however, unplanned circumstances force people to withdraw funds from their 401 early. So if you find yourself in a place where you need to tap your retirement funds early, here are some rules to be aware of and some options to consider.
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How Taking A 401 Distribution Affects Your Retirement
Time in the market and compounding interest are critical factors when it comes to your retirement savings. While investment returns will vary, in general more money in the market means more at retirement, while anything you withdraw now is that much less you’ll have for your golden years. Plus, taking money out means missing any potential gains your investments would have seen along the way, even if you reinvest the money down the road.
That’s why it’s important to carefully assess your situation if you’re experiencing a true emergency and your retirement is your only financial source, consider limiting the amount you take out to only what you need. If you’re certain that you can pay yourself back, there’s also less of a risk in going this route. But if you can go without touching your nest egg, over time you may be able to reap the rewards of compound interest and avoid any potential losses.
