What Happens If You Take an Early Withdrawal From a 401(k) or IRA?

Key Points

  • It's possible to take an early withdrawal from your IRA or 401(k) but it can be complicated—and costly.
  • Roth accounts provide a more straightforward early withdrawal option than traditional retirement accounts.
  • Remember why you opened your retirement accounts in the first place and consider other sources for needed funds first.

Dear Carrie,

Am I allowed to take an early withdrawal from my 401(k) or IRA? What happens if I do?

—A Reader

Dear Reader,

Great question—and one that I hear often. As you watch your money accumulate in a retirement account, it's natural to want to use some of it early, especially if you're in an economic bind. But it's important to remember that you'll also need those funds in the future. After all, that's why you opened the account in the first place.

While I always recommend using early withdrawal from a 401(k) or IRA only as a last resort, if you find yourself in a financial crunch, it is possible to make early withdrawals (early being defined by the IRS as before age 59½) in certain circumstances. However, it's complicated—and can be costly.

You didn't mention if your accounts are traditional or Roth, so let's go over the basics of each first because there are important differences between the two.

Basic early withdrawal rules for traditional and Roth retirement accounts

If your 401(k) or IRA is traditional, your contributions are pre-tax. Any distributions of contributions or earnings at any time are subject to ordinary income taxes. Plus, there's most likely a 10 percent penalty if you're under age 59½.

If an account is a Roth, your contributions are made after taxes, and you can withdraw up to the amount of your contributions at any time—at any age—without taxes or penalties.

That's the simple answer. But of course, it's more complex than that because there are rules—and exceptions. And here's where the devil's in the details.

Basic early withdrawal rules for traditional and Roth retirement accounts

An early withdrawal from a traditional 401(k) will be taxed as regular income and typically incurs a 10 percent penalty. In real terms, this means that if you’re younger than 59½ and you’re in the 25 percent tax bracket, if you take $10,000 from your traditional 401(k), you'll pay $2,500 in federal taxes and $1,000 in IRS penalties (plus, you may owe state taxes). Your $10,000 will cost you $3,500—a pretty hefty price.

But taxes and penalties aside, the real issue here is that if you're still employed by the company sponsoring your plan, you can only take early withdrawals in very specific situations—if at all. For instance, you might qualify for what the IRS calls a "hardship distribution" if you can prove immediate and heavy financial need to pay for certain qualified expenses such as funeral or higher education costs, as set by the IRS. (You can get the complete list at irs.gov.)

But here's the catch. Even if the IRS allows a hardship distribution, your plan may not. Plus, no matter why you need the money, you'll still pay taxes and a 10 percent early withdrawal penalty. To avoid the penalty you must meet some even more stringent requirements, for instance if your medical debt exceeds 7.5 percent of your adjusted gross income or if you become permanently disabled.

Another negative is that if you take a hardship distribution, you can't make a contribution to your 401(k) for six months—and you can't ever pay it back.

There are a couple often overlooked penalty-free possibilities if you are separated from service. If you leave or lose your job in the year you turn 55 (or later), you can take a lump sum 401(k) distribution without incurring the 10% early withdrawal penalty. If you have separated from service at any age before 55, you can set up "substantially equal payments" over your lifetime, which must be a minimum of five years or until you reach age 59½, whichever is longer.

Taking a loan from your traditional 401(k)

If your employer's plan allows it, a tax-free, penalty-free loan from your 401(k) might be the best option in a pinch. Your employer sets the terms, but it must be paid back on time (within five years unless you are borrowing to purchase a home)—and with interest—or be subject to taxes and penalties.

Plus, if you lose your job during the life of the loan, you generally have to pay it back in full at termination or within 60 days from termination. That can be a challenge.

Early withdrawal from a traditional IRA

Traditional IRAs are a little more flexible. You can take an early distribution at any time, subject to taxes and a 10 percent penalty before 59½. However, you can avoid the penalty if the money is used to pay for specified costs, including higher education, a first-time home purchase (but only up to $10,000) and medical expenses exceeding 7.5 percent of your adjusted gross income. But no matter the circumstances, you'll always pay income taxes on withdrawals.

Early withdrawal from Roth accounts

Roth accounts are the easiest. Both contributions and earnings are tax and penalty free at age 59½ as long as you've held the account for five years. And, as I said, you can take early distributions of contributions from a Roth 401(k) or IRA at any time without taxes or penalties. Any earnings on your contributions taken out before age 59½ could cost you.

The most important rule to follow

From possible taxes to penalties to—most of all—the loss of long-term growth, an early withdrawal from a retirement account can really take a chunk out of your hard-earned savings. So the most important rule is a personal one—doing what's best for you in the long run. Think carefully and make sure you consider the long-term as well as the upfront costs. And as always, consult your tax advisor before taking any distributions. 

Have a personal finance question? Email us at askcarrie@schwab.com. Carrie cannot respond to questions directly, but your topic may be considered for a future article. For Schwab account questions and general inquiries, contact Schwab.

 

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