What happens when you make an early 401(k) withdrawal?
Picture this: you’ve left your office for the last time. You’ve spent the better part of your career preparing for this exact moment and have finally reached retirement bliss. You have an open horizon stretched out in front of you—filled with relaxation, plenty of travel, time spent with the grandkids, opportunities to enjoy and explore new hobbies…your retirement looks very promising.
Now imagine those magnificent golden years being ripped away from you—and in their place, many more years spent working in that same office you just pictured yourself leaving. This nightmare is a reality for many workers, due in part to poor planning, inadequate preparation, and insufficient education on what it takes to reach true retirement readiness. One of the most misunderstood retirement basics is what really happens when you make an early withdrawal from your 401(k) plan.
When can you withdraw from your 401(k)?
It comes as no surprise that many employees are unsure when they can actually start accessing the funds in their 401(k) account.
The 401(k) regulations allow for distributions in these situations:
- The employee's death, disability, or severance from employment
- The employee's attainment of age 59½, or the employee's hardship
- The plan is terminated
Additionally, the 401(k) plan document would need to be checked to see if in-service distributions after age 59½ and hardship distributions are even permitted; some plans do not allow for these types of distributions.
But keep in mind: when you can withdraw from your 401(k) and when you should withdraw from your 401(k) are vastly different things.
Wondering why or how someone might want to withdraw 401(k) savings early in the first place? It’s actually a fairly common scenario. When workers change jobs and have to decide what to do with the funds in their old 401(k) plan, it can be a tempting option to simply “cash out” rather than go through the paperwork of rolling funds over into the new plan or letting them sit where they are. Why not withdraw the funds and put some extra cash in your pocket right now? Because there are some major consequences of taking an early withdrawal from your 401(k) account, for starters—but more on that in just a minute. Let’s talk the basics first.
401(k) withdrawal rules
Withdrawals and distributions from 401(k) accounts are highly regulated, designed to discourage savers from trying to tap into their retirement savings early. As such, there are a few things you’ll want to be aware of before deciding to take an early withdrawal. Below are some commonly asked questions about 401(k) withdrawals and distributions.
Do I have to claim a 401(k) withdrawal on my taxes?
Yes—your 401(k) withdrawal is subject to federal income tax.
(The income tax does not apply to any after-tax contributions you may have made, like in a Roth account for example. It also does not apply if you rollover your withdrawal to an IRA or another retirement plan.)
Depending on the amount you withdraw and where you live, you may need to pay state or local taxes as well. If you tap into your 401(k) before you reach age 59½, you’ll also have to pay an additional 10 percent penalty tax. There are certain exceptions for rare circumstances—including distributions to beneficiaries, due to disability, for medical expenses exceeding 10 percent of your income, or if you terminate employment after age 55—that allows you to withdraw funds early without penalty. However, in normal circumstances, you can bet on paying federal income tax at the very least on all early withdrawals.
Can I take money out of my 401(k) to buy a house without penalty?
Buying a house is expensive—between paying the realtor, financing closing costs, and putting down a down payment, you’ll need quite a chunk of change saved up to successfully purchase a home. If you already have that type of money saved in a retirement account, it may be tempting to tap into it to help speed up the process. But taking money out of your retirement savings account early, no matter the circumstance, could be a costly mistake. There are no penalty exemptions for the purchase of a new home, so the money you take out of your 401(k) to help pay for your house would be subject to the 10 percent early withdrawal penalty and income tax as normal.
When are 401(k) withdrawals required?
Although we’re mainly focused on early withdrawals, it’s important to note that 401(k) withdrawals are required once you reach a certain age.
Effective December 29, 2022, the Required Minimum Distribution (RMD) rules were modified to increase the age at which a participant must take an RMD from age 72 to age 73 for individuals born in 1951 or later.
RMD rules apply to:
- Any participant born in 1950 or earlier, who is age 72, and who is:
- No longer employed at of the end of the calendar year
- More than 5 percent owner of the company (this applies to all more than 5 percent owners regardless of employment status)
- Any participant born in 1951 or later, who is age 73, and who is:
- No longer employed at the end of the calendar year
- More than 5 percent owner of the company (regardless of employment status)
If you were born in 1951 or later and have not reached age 73, you will not be required to receive an RMD until you turn 73.
You’ll be required to begin taking an RMD—with the amount calculated based on life expectancy and the balance of your 401(k) at the end of the prior year. You’ll be mandated to withdraw at least the amount of your RMD—and you’ll face serious penalties if you fail to do so. Failure to withdraw your RMD each year will result in a 25 percent penalty on the amount you failed to withdraw (though it can be reduced to a 10 percent penalty if corrected timely), so make sure you’re up to date on the requirements when that time comes.
Consequences of early 401(k) withdrawals
As we mentioned earlier, there are plenty of reasons to avoid taking an early 401(k) withdrawal—even if it seems like an ideal option at first glance. To start: any and all early 401(k) withdrawals (with exceptions for rare circumstances and Roth accounts) are taxable as normal income. That doesn’t sound like such a big deal, right? Maybe you’ll feel differently after a real-world example.
Let’s say you’re in your 30s with an annual salary of $60,000, and you’ve built up a nice little nest egg of $30,000. You just started a new job and decide to withdraw the $30,000 from your old 401(k)—rather than roll it over to the new plan—to help pay for a new luxury vehicle you’ve had your eye on for a while.
Congratulations! You’ve just bumped yourself up into the next tax bracket. Taxable as ordinary income, remember?
What’s more, that $30,000 withdrawal is subject to a 10 percent penalty fee for accessing the funds early. So, another round of congratulations are in order; you’re now not only in a higher tax bracket, but you also lost $3,000 just like that.
The consequences don’t end there, either. There’s a big opportunity cost of accessing 401(k) funds early; you aren’t just losing money on the taxes and penalties that come along with early 401(k) withdrawals, but you’re also losing out on the potential future growth those funds would enjoy while they’re invested. You’re sacrificing compounding interest—which is known to significantly increase the size of your nest egg over the course of a career—on the funds that are withdrawn.
Plus, annual contribution limits can make it difficult to catch up later on in your career if you withdraw a big chunk of your retirement savings early. You don’t want to risk your future financial security or put your retirement in jeopardy by taking an early withdrawal just to help pay for a nicer house or newer car. With an annual 401(k) contribution limit of $22,500 for those under the age of 50, taking a $30,000 early withdrawal like in the example above would set you more than a year and a half behind in your retirement savings.
“But I don’t plan on ever retiring, so it’ll be fine.”
Will it, though? Recent studies show that nearly half of current retirees ended up retiring sooner than they planned. 1 But that could be because they reached financial security and felt comfortable to retire when they thought they would never be able to, right? In theory, yes. But in reality, two-thirds of those who retired earlier than planned cited reasons that were out of their control—such as their own ill health, company downsizing, or family responsibilities.1
Clearly, it’s not a good idea to count on the notion that you’ll never retire. Unless you have a crystal ball, you don’t know what circumstances you’ll run into years down the line—and it’s better to be prepared for all of life’s curveballs than face a financially unstable retirement because of poor planning. So, instead of giving in to temptation and taking an early 401(k) withdrawal or cashing out early, leave those 401(k) funds where they are and put yourself further along the path to retirement readiness. And if you have any questions in the meantime, we’re here to help. Check out our educational resources contact one of our retirement specialists today!