Guidelines for Retrieving Funds from 401(k) Plans

A 401(k) is an advantageous retirement savings account where you can contribute money before taxes are deducted. Contributions often come directly from your paycheck.

When it comes to withdrawing funds from a 401(k, certain restrictions apply due to its tax-advantaged nature. If you withdraw prior to reaching 59 ½, penalties might be charged.

Let me explain the mechanics of withdrawing from a 401(k), including the costs of early withdrawals and circumstances exempt from penalties.

Qualified distributions

Comprehending qualified distributions

Typically, 401(k)s are considered as qualified plans and enjoy favorable tax treatment. A qualified distribution usually occurs when you withdraw money after reaching 59 ½. You can withdraw as much as you like at this age.

When you make a qualified distribution from a 401(k) after reaching 59 ½, you are taxed at your ordinary income tax rate, except for Roth 401(k)s, which are funded post-tax and provide tax-free withdrawals. You are required to take qualified distributions from your 401(k) after 59 ½ if you have a traditional 401(k). However, starting in 2024, RMDs are not necessary for Roth 401(k)s due to new rules introduced by the SECURE Act.

The IRS calculates the required minimum distributions (RMDs) based on your age, life expectancy, and the amount in your retirement account.

Although there are additional rules for Roth 401(k) withdrawals to be considered as qualified—including a requirement that Roth 401(k)s be open for at least five years prior to the first distribution—these rules do not apply to traditional 401(k) accounts.

Early withdrawals

Understanding early withdrawals

Early withdrawals occur when money is withdrawn from a 401(k) before 59 ½. In most, but not all, circumstances, this results in an early withdrawal penalty of 10% of the withdrawn amount.

For example, withdrawing $10,000 early would result in paying $1,000 in tax to the IRS. This is in addition to the tax due on 401(k) withdrawals, which is based on your ordinary income tax rate.

When you withdraw money early from a 401(k), the funds cease to generate income from compounding. While early withdrawal penalty is often highlighted, the opportunity cost of withdrawing funds prior to retirement is significantly higher.

If $10,000 is withdrawn from a 401(k) at 30, the account balance would be almost $107,000 lower at 65 (assuming a 7% average annual return on investment) than if the money had remained invested.

Hardship withdrawals

Requirements for hardship withdrawals

The IRS allows penalty-free distributions before 59 ½ in hardship-related circumstances—when your, your spouse’s, or a dependent’s "immediate and heavy financial need" necessitates the withdrawal, and the amount withdrawn satisfies the financial need.

Certain medical expenses, purchasing a primary home, tuition and educational fees, repair of certain primary home damage, and preventing eviction or foreclosure from a primary home are some scenarios that might constitute an immediate and heavy financial need.

Your plan administrator may not permit hardship withdrawals regardless of circumstances. And, the IRS requirements specify that you must not have any other source of funds to cover the expenses.

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Other ways to avoid the early withdrawal penalty

You can also avoid the penalty under certain circumstances, such as:

Being disabled.
Financial obligations leading to the distribution of some 401(k) funds.
Agreeing to a series of substantially equal payments for at least five years, or until 59 ½.
Leaving your job in the calendar year you turn 55.

Another alternative to avoid early withdrawal penalty is by considering a 401(k) loan. If offered, 401(k) loans are easy to obtain, allowing you to borrow from your 401(k) account and repay yourself with interest. Provided that you repay a 401(k) loan on schedule, you can circumvent the consequences of an early 401(k) withdrawal.

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In the context of retirement planning, it's important to understand that making a qualified distribution from a 401(k) after reaching 59 ½ means you'll be taxed at your ordinary income tax rate. On the other hand, when you need to withdraw money before reaching 59 ½, you might face an early withdrawal penalty of 10% of the withdrawn amount, as well as paying tax based on your ordinary income tax rate.