6 Things You Didn't Know About Early 401k Withdrawals
Whether you're leaving a job or facing financial hardship, the temptation may arise to cash out your 401(k) retirement plan early. Depending on the circumstances, it might even be the best course of action.
Your 401(k) is an employer-sponsored retirement account, fed by agreed-upon reductions from your paychecks and meant to grow over time. Typically, when you leave the employer that operates your 401(k), you roll it over to a new employer or into an Individual Retirement Account (IRA).
Sometimes, however, for a variety of reasons, you may want to get to that money sooner than retirement.
Unlike standard checking and savings accounts, accessing 401(k) funds comes with many catches. There are rules to slow down the process and penalties to dissuade all but the most dedicated early withdrawers. It's enough to give one pause ... and maybe rightly so.
This post will guide you through the typical 401(k) early-withdrawal process and it will highlight the complications that can arise if you proceed with the idea. Read on to understand the potential pitfalls of touching those retirement savings too soon.
1. How Early is "Early"?
Put simply, any time before age 59 ½ is the time-frame in which early 401(k) withdrawals incur penalty fees.
2. Can Anyone Withdraw Early?
Not exactly. Would-be withdrawers have to show the government that they're operating under a hardship and really need that 401(k) money. Acceptable reasons include:
- To cover medical expenses
- To cover funeral expenses
- To buy a house
- To avoid foreclosure or eviction from your primary residence
- To pay a college tuition bill that's due within 12 months
Some plans allow for additional flexibility when it comes to what defines a hardship. So, turn to the documentation that your employer provides regarding your 401(k) account and be prepared to show documents that prove you can meet one of the hardship rules for withdrawing your money.
3. What are the Fees?
Account holders younger than 59 ½ pay a 10% fee calculated on the total 401(k) monies that are withdrawn.
4. Taxes on Early 401(k) Withdrawal
The Internal Revenue Service won't tax 401(k) funds while they're in your account, but it will tax every dollar that you withdraw from it, no matter what your age is when you take it out. The bottom line is that the money is always treated as income.
So whenever you elect to withdraw those retirement funds, have a plan in place to deal with the IRS. Either be ready for a large lump sum demand on your next tax bill or set up an installment plan to lessen the blow. BackTaxesHelp.com publishes this helpful guide to making installment payments to the IRS.
5. Are There Any Fee Exceptions?
When it comes to fees, exceptions are made for qualifying individuals. The circumstances that could trigger a penalty exception include:
- You leave your job, whether voluntarily or involuntarily, after the age of 55
- Your medical expenses exceed 7 ½% of your adjusted gross income
- A court orders the money given to a divorced spouse or to a dependent
- You leave work and set up a special withdrawal plan intended to last the rest of your lifetime
- You become disabled
As you can see, it gets a bit complicated. The IRS does provide some written guidelines that further explain how 401(k) funds can be distributed and what are the exceptions to the usual fees. Click here to check them out.
6. What If I Don't Withdraw All My 401(k)?
You needn't pull all the funds out of your plan, but if you leave money in the account and you still intend to continue to contribute to it, there's often a waiting period before you can resume your contributions. Typically, a plan will pause contributions to the 401(k) for six months after a hardship withdrawal.
With this advice in mind, it might also be a good idea to take your early-401(k)-withdrawal plan to a qualified tax accountant or a tax lawyer -- someone who can help unpack all of the details of your particular plan.
One reason to do so is that you'll also want to understand how the income change -- the one that the IRS will evaluate on your next yearly return -- impacts your tax bracket. That is, if you withdraw enough from a 401(k) to get bumped to the next income level, what you're used to paying in taxes could suddenly jump quite a lot more.
And, as Bills.net points out, even a small error in filing a return under your new 401(k) withdrawal circumstances can go undetected for years. Then, if the IRS finds it and catches up with the discrepancy, the amount owed can be subject to further fees and interest.