Thinking of Taking an Early 401(k) Withdrawal? Consider the Ultimate Cost.

Key Points

  • While your 401(k) balance may be tempting, taking a distribution before age 59½ can result in penalties and taxes.
  • If your retirement plan allows it, a 401(k) loan is potentially a less costly way to take some cash.
  • Leaving your 401(k) intact makes the most economic sense unless you have an urgent financial need.

Dear Carrie,

If you're younger than 59½, is it possible to withdraw money from your 401(k) without having to pay it back?

—A Reader

Dear Reader,

The balance in your 401(k) can be a tempting source of cash when times are tough and you have no other options. And yes, it's possible to take an early distribution without having to pay it back, depending on your personal situation and your specific plan.

But possible doesn't necessarily mean practical in terms of your financial future—and the IRS doesn't make it easy! There are a lot of rules and regulations. So before taking any money from your 401(k), I'd take a step back and carefully review the basics as well as the short- and long-term costs.

Basic taxes and penalties

First, no matter your age, all 401(k) distributions are taxed as ordinary income in the year in which the money is received unless it's a Roth 401(k). Plus, unless you meet specific criteria, early distributions are subject to an additional 10% penalty. Together, this could take a huge bite out of your distribution—not to mention your future retirement savings.

Criteria you have to meet

If your plan allows it, you may qualify for what is called a "hardship distribution" as long as you prove immediate and heavy financial need. The amount of the hardship distribution is limited to your own contributions to the plan and possibly your employer's contributions but doesn't include earnings or income on your savings. The terms of proof once again depend on your plan, but in general, the IRS defines immediate and heavy financial need as:

  • Medical expenses for you, your spouse or dependents
  • Costs directly related to the purchase of your principal residence (excluding mortgage payments)
  • Post-secondary tuition and related educational fees, including room and board for you, your spouse or dependents
  • Payments necessary to prevent you from being foreclosed on or evicted from your principal residence
  • Funeral expenses
  • Certain expenses relating to the repair of damage to your principal residence

What you stand to lose

Regardless of why you need the money, you have to pay both income taxes (unless it's a Roth) and the 10 percent penalty. Let's put that into real numbers. Say you want to take $20,000 from your 401(k) and you're in the 25% tax bracket. Income taxes on your distribution could be $5,000. Now add the 10% penalty of $2,000. Your $20,000 could end up costing you $7,000 or 35%—a hefty price for the use of your money.

Next, figure out how much you're losing in potential earnings over time. For example, if that $20,000 were left in the account and grew at a hypothetical annual interest rate of 5 percent for another 15 years, you'd have over $41,500—more than double your money!1

Finally, even though you continue to make contributions, annual 401(k) limits will make it hard to recoup your losses. On top of that, in certain circumstances, you're not allowed to make additional contributions for six months after the withdrawal. That's six months of lost savings!

Some penalty-free options

There are some exceptions to these rules. For instance, if you leave or lose your job in the year you turn 55 (or later), you can take a lump sum 401(k) distribution. You can also set up a payment schedule of “substantially equal payments" over your lifetime, which has to be a minimum of 5 years or until you reach age 59½, whichever is longer. This is known as separation of service and while both situations are penalty-free, you'd still pay income taxes.

The penalty is also waived if you become disabled; you die and a payment is made to your beneficiary or estate; you pay for medical expenses exceeding 7.5% of your adjusted gross income; or the distributions were required by a divorce decree or separation agreement ("qualified domestic relations court order").

Another less costly option—a 401(k) loan

A 401(k) loan is potentially a less costly way to take some cash if your retirement plan allows it. There are no penalties or taxes, but you do have to pay interest. On the plus side, that interest is going back into your own account, so in a sense you're paying it to yourself. However, repayment schedules are strict and failure to repay may trigger penalties and taxes. Also, if you lose your job or change jobs, in most cases you have to pay back the entire loan within 60 days of termination. If you don't, once again you'll likely be hit with penalties and taxes.   

The ultimate cost

To me, taking an early distribution should be a last resort, so I'd advise you to think carefully and talk to your tax advisor. Make sure you understand what a distribution would mean in terms of upfront dollars and lost opportunity for growth. While it may seem like the answer to a current financial need, by depleting your retirement savings now, you could be sacrificing your future financial security. That's the ultimate cost.

Next Steps

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