401(k) early withdrawal penalty

Can you withdraw money from a 401(k) early?

Yes, you can withdraw money from your 401(k) early. But unfortunately, you can’t (under normal circumstances) withdraw money early from your 401(k) without facing certain consequences, like the 10% penalty and missed growth. If you wait until you’re at least 59½ years old to withdraw from your 401(k), you can do so without the penalty. 

Why is there a penalty for early withdrawals from your 401(k)? It’s your money, after all. Retirement plans, including 401(k) plans, are designed by the government to encourage long-term retirement savings. Penalties help to discourage people from taking money out of their retirement accounts early and losing out on compound interest.

What is compound interest? Compound interest is when you earn interest on the interest that your money has already earned, not just on the money you originally invested. Think of it like a snowball rolling down a hill. Your investment starts small but grows bigger and bigger as it picks up more snow (or in this case, more interest) along the way. Thanks to compound interest, the longer your money stays in your 401(k), the more it can grow.

Penalty or no penalty, life happens, and there are many reasons you may need to access the funds in your 401(k) early. However, it’s important to understand all the options available to you, as well as the rules and tax obligations associated with those options.

What is a 401(k) loan?

A 401(k) loan allows you to borrow money from your retirement account rather than just taking a withdrawal from it. This can be a beneficial option if you need cash but don’t want to deal with the penalty and tax of early withdrawal.

Here’s how 401(k) loans work

If your 401(k) plan allows loans, you will usually be able to borrow up to 50% of your vested balance. The maximum you can take is $50,000, and you’ll be required to pay back this loan, with interest, within 5 years.

Pros and cons of a 401(k) loan

Can I take out my 401(k) to pay off debt?

Yes, you can withdraw funds from your 401(k) to pay off debt. However, if you do so before you reach the age of 59½, you’ll have to pay a 10% early-withdrawal penalty and income tax on what you withdraw. 

It’s also important to consider the impact that withdrawing from your 401(k) early has on your retirement goals. Thanks to compound interest, your funds gain a lot of value by simply staying in your retirement account. You could be undercutting that value and risking your security in retirement if you withdraw the funds early.

In some cases, taking out a 401(k) loan may be a better option for paying off debt than directly withdrawing from your 401(k). You’ll have to pay this money back, but you’ll likely get a better rate than your existing debt, especially if you’re paying off credit card debt.

If you’re facing eviction or foreclosure because of your debt, you may also be able to take a hardship withdrawal from your 401(k) to cover missed housing payments.

Hardship 401(k) withdrawal

A hardship 401(k) withdrawal allows you to take money out of your 401(k) when you’re facing an immediate financial need. You’ll still have to pay income tax on what you withdraw, but the 10% penalty will typically be waived.

What qualifies as a hardship?

• Preventing eviction or foreclosure: As we mentioned previously, if you’re facing eviction or foreclosure, you may qualify for a hardship withdrawal to help you catch up on housing payments you’ve missed.
• Medical expenses: Insurance or no insurance, medical bills can really add up. If you, your spouse, or your child or other dependent has medical expenses that insurance won’t cover, you may be able to use a hardship withdrawal to pay for them.
• Education costs: The average cost of in-state tuition for a student who lives on campus is $108,584 per year. If you, your spouse, your child or other dependent is attending college, you can usually use a hardship withdrawal to pay for tuition, room and board, fees, and other education costs.
• Home purchase: Need help saving up for a downpayment for a home? If you’re buying your primary residence (the house you’ll live in full-time for at least two years), you can likely qualify for a hardship withdrawal to cover purchasing a home.
• Disaster-related home repairs: Did you know that the national average cost of home repairs due to extreme weather damage is $12,299? If you’re facing costly repairs after a natural disaster, a hardship withdrawal may be able to help you cover the expenses.
• Funeral expenses: Have you recently lost a loved one? If you need help covering the funeral costs of a family member, you likely qualify for a hardship withdrawal.

If you’re thinking about taking a hardship withdrawal, it’s important to research the specifics of your 401(k) plan. Not all 401(k) accounts allow for hardship withdrawals, and your employer may have unique rules that dictate how they work. Talk to your plan administrator to learn the ins and out of your plan.

Pros and cons of a hardship withdrawal

How much taxes do I pay on 401(k) early withdrawal?

When you take an early withdrawal on your 401(k), the IRS considers the funds to be taxable income. That means you’ll have to pay income tax on what you withdraw. The rate you’ll pay depends on your tax bracket.

In addition to having to pay your normal income tax rate on what you withdraw from your 401(k), you’ll also have to pay a penalty for early withdrawal. The IRS charges a 10% penalty on any funds you withdraw early from your 401(k).

That means that if you’re withdrawing $10,000 from your 401(k) before you’re 59½ years old (or before you’re 55 and retired), you’re looking at a $1,000 for the penalty, plus another $2,200 in tax (more or less, depending on your tax bracket). 

At what age is 401(k) withdrawal tax free?

If you have a traditional 401(k), you’ll have to pay income tax (federal and potentially also state) on any money you take out of it, regardless of your age. That’s because traditional 401(k)s are funded with pre-tax dollars.

On the other hand, Roth 401(k)s are funded after income tax is paid. That means that anything you withdraw from a Roth 401(k) will be tax-free, as long as the account has been open for at least five years.

You may be wondering why you should wait until your 59½ years old to withdraw from your traditional 401(k) if you’ll have to pay income tax on it either way. The answer is the 10% penalty.

Ways to take penalty-free withdrawals from your 401(k)

1. Wait until you’re 59½ years old: The IRS won’t charge a 10% penalty for withdrawing from your 401(k) if you are at least 59½ years old.
2. Wait until you’re 55 years old to retire: The “Rule 55” says that if you’re at least 55 years old and you’ve lost your job or retired, you can take withdrawals from your 401(k) penalty-free.
3. Consider a SEPP plan: A substantially equal periodic payments (SEPP) plan is a series of periodic payments from your 401(k) when you stop working. This allows you to take penalty-free withdrawals early; however, these plans usually have specific rules you’ll need to follow carefully in order to continue avoiding the penalty.
4. Take out a 401(k) loan: Borrow money from your 401(k) penalty-free with a 401(k) loan. Keep in mind that you’ll have to pay it back with interest within five years.
5. Take a hardship withdrawal: If you qualify for a hardship, you will typically be able to take a withdrawal from your 401(k) without having to pay the 10% penalty.

Other scenarios when the IRS will typically waive the early-withdrawal penalty

• Divorce settlements: In a divorce, if the court orders you to split your 401(k) with your ex-spouse, you can usually do so without the penalty.
• Domestic abuse: If you’re a domestic abuse survivor, you can withdraw the lesser of $10,000 or 50% of your 401(k)-balance penalty-free.
• Terminal illness diagnosis: If you’ve been diagnosed with a terminal illness, you can withdraw from your 401(k) early without facing a penalty.
• Disability: If you’ve become permanently disabled, you can take early, penalty-free withdrawals from your 401(k).
• Retirement plan rollover: You can roll your 401(k) balance over to a new retirement account within 60 days penalty-free.
• Birth or adoption: If you’ve had a child, you can withdraw up to $5,000 per retirement account without paying the 10% penalty.
• Disaster relief: You can usually withdraw 401(k) funds penalty-free if you’ve been impacted by a natural disaster.
• Military reservist called to active duty: If you’re a military reservist and you’re called to active duty, the IRS will typically allow you to make penalty-free withdrawals from your retirement account.
• Auto enrollment or excess contributions: You can typically withdraw funds penalty-free within certain limits if you were automatically enrolled in your 401(k) and you want out, or if you over-contributed to your account.
• Death: After you pass away, your estate or beneficiary can withdraw funds from your 401(k) without paying the penalty.

Whether you’re considering retiring early or need to withdraw money from your 401(k) early to help cover your financial bases, it’s important to understand your options and tax obligations. Work with a Jackson Hewitt Tax Pro. We’re open year-round and ready to help