Do you dream about a retirement where you escape away to your cabin in the woods, or one where you’re flying your grandkids to Europe for an epic vacation? Making this dream a reality requires tucking money away for the future. And for many people, the place to do that may be within a 401(k) account.
A 401(k) account is designed for retirement saving. One of the reasons Investors may prefer it over saving and investing in a brokerage account is because it is not subject to federal income taxes until distribution.
You might be trying to keep the money in your 401(k) until retirement, but sometimes, life happens, and there may be situations where you need some extra cash. It is only natural to look at all of the available options, and that may include the option of tapping into your 401(k) funds.
You may want to proceed with caution, though. Because of the special taxation of this account type, the 401(k) has an early withdrawal penalty. Therefore, it may be worth exploring other options.
To answer the question, “what is the penalty for withdrawing from a 401(k)?” it helps to understand how a 401(k) works in the first place. Here’s some good things to know about the 401(k) early withdrawal penalty, along with some ideas on how to access cash without using funds from your 401(k) account.
How Does a 401(k) Work?
A 401(k) is an account designed to hold money and investments for retirement. Why does it have such a funky name? Well, it’s named after a line in the tax code that gives the 401(k) it’s special taxation. It’s a reminder that rules regarding 401(k) accounts are set by the IRS and generally have to do with taxation.
Essentially, the IRS allows investors to stash a certain amount of money away each year for retirement, without having to pay income taxes on those contributions.
In 2020, that contribution maximum amount is $19,500 per year , with additional catch up contributions allowed for those 50 and older. Additionally, the investments within the account are allowed to grow tax-free.
401(k) participants can’t avoid paying income taxes forever, though. When retirees go to pull out money in retirement, they must pay income taxes on the amount withdrawn.
So, while you have to pay income taxes eventually, the idea is that maybe you’ll pay a lower effective tax rate as a retired person than as a working person. (Although, none of this is guaranteed because we can’t predict future tax rates.)
The IRS classifies 59½ as the age where a person can begin withdrawing from their 401(k). Before this age and without an exception, it is not possible to do a 401(k) withdrawal without penalty.
What is the Penalty for Withdrawing from a 401(k)?
When a 401(k) account holder withdraws money from a 401(k) before age 59½, the IRS may charge a 10% penalty in addition to the ordinary income taxes assessed on the amount.
Unqualified withdrawals from a 401(k) are considered taxable income. Then, the 10% penalty is assessed on top of that. This could result in a hefty penalty.
Is a 401(k) Withdrawal Without Penalty Possible?
There are some exceptions to the 401(k) early withdrawal penalty rule. For example, an exception may be made in the event that a participant has a qualifying event such as a disability or medical expenses, and must use 401(k) assets to make payments under a qualified domestic relations order, has separated from service during or after the year they reached age 55, or that a distribution is made to a beneficiary after the death of the account owner.
Additionally, it may be possible to avoid the 401(k) withdrawal penalty through a method known as the Substantially Equal Periodic Payment (SEPP) rule. These are also called 72(t) distributions.
To do this, the account owner must agree to withdraw money according to a specific schedule as defined by the IRS. The participant must do this for at least five years or until they have reached age 59½.
Under the 72(t) distribution, a participant will systematically withdraw the total balance of their 401(k). While this is technically an option in some instances, it does mean taking money away from retirement. Consider this while making your ultimate decision.
Alternatives to an Early 401(k) Withdrawal
Because of the steep penalty involved, you may feel inclined to shop around for some alternatives to early 401(k) withdrawal.
Participants can consider taking a loan from their active 401(k). The money is removed from the account and charged a rate of interest, which is ultimately paid back into the account. The interest rate is generally one or two points higher than the prime interest rate set by the IRS, but it can vary.
While this loan may come with a competitive interest rate that is repaid to the borrower themself and not a bank, there are some significant downsides. First, taking money from a 401(k) account removes that money from being invested in the market. A participant may miss out on the market’s upside and compound returns.
Though a 401(k) loan might seem like an easy option now, it could put a person’s retirement at risk.
It is easy to imagine a scenario where the loan does not get repaid. If the loan is not repaid, the IRS could levy the 10% penalty on the distributed funds.
Additionally, money that is repaid to a 401(k) is done with post-tax money. The money that is borrowed from the 401(k) would have been pre-tax money, so replacing it with money the borrower has already paid taxes on may make a 401(k) loan more expensive than it initially seems.
In addition, if a person were to leave their company before the loan is repaid, the loan would need to be repaid by the time you file your taxes for that year or penalty and income tax could be due. Participants should proceed down this route with caution.
Unlike with a 401(k), income taxes are paid on money that the account holder contributes to the account. Therefore, these funds aren’t taxed when the money is removed. (This only applies to contributions, not investment profits.)
Again, common advice states that removing money from any retirement account should generally be considered a last-resort option. The average person is already behind in saving for retirement, so even Roth IRA funds should only be considered after all other options are exhausted.
By using a personal loan, the participant is able to avoid a 401(k) early withdrawal penalty and leave all of the money invested within the account to grow uninterrupted.
A personal loan also puts the borrower on an amortized payback schedule that has a defined end-date. Having a defined payback period may be beneficial during debt repayment—it provides a goal, and it is clear how progress is made throughout the life of the loan.
Compare the set amortization of a personal loan to a revolving credit card, where it can be quite tempting to add to the balance, even as the person is attempting to pay it off in full.
When charges are added to a credit card, the end-date can be pushed out further, especially in the event that the borrower is only making minimum payments. This is not the case with a personal loan where a lump sum loan amount is disbursed and paid back within a set timeframe.
With all of the above options, it is recommended to sit down and map out the cost of each. To do this, you may want to consider using a personal loan calculator and/or working with a tax advisor or financial advisor to help identify the best course.Ultimately, it will be up to you to research the best option given your needs.
Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.
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