Posted by Pat Raskob

Rules for Early Withdrawal from Your Retirement Account

Rules for Early Withdrawal from Your Retirement Account

Many people would love to withdraw early from their 401(k) since they feel it is their money. However, some rules make this a bad idea. 

401(k) exist in two types – Roth and traditional. With the traditional, you can set some funds aside for use in retirement with the tax-deferred. The implication is that whenever you pay into the account, it brings down your taxable income. In addition, the money will grow tax-deferred until you can make a penalty-free withdrawal after turning 59½. 

The Roth option, on the other, is not offered by all employees, and it also allows your fund to grow tax-deferred. However, you only contribute money after paying your taxes. With this, when you withdraw, you will not pay taxes. 


Withdrawing from your 401(k): Early Withdrawal Might Cost You

Many things can make your finances take a hit, like an accident, illness, sudden job loss, etc. This makes many people resort to withdrawal from their 401(k). You, however, need to be careful as this might come with long term implication which could thwart your plan of a comfy retirement 

Withdrawal from your 401(k) should be a last resort because Uncle Sam will tax such at the income tax rate, and there will be an early penalty withdrawal of 10%. The idea behind this penalty was to discourage people from early withdrawal.

On the other hand, there are neither penalties nor tax, provided the withdrawal was five years after you made the Roth 401(k) contribution, and your age is 59.5 or above. Again, this is because the funds paid here are an after-tax dollar. 

It is possible to have early withdrawal from the 401(k) before getting to age 59.5 even if you didn’t meet the five-year rule but with a caveat. Since your withdrawal will typically include your personal contributions and gains from such, such withdrawal will have to be prorated based on the available percentage resulting from each contribution present in your portfolio. Even though your contributions are tax-free, any gains on such will have a 10% penalty alongside the income tax rate.


Hardship Withdrawal 

As long as it is allowed in your employer plan, you can gain easy access to your retirement fund via hardship withdrawal – a sudden and demanding financial need. Unfortunately, such withdrawal brings down your portfolio balance permanently, and you are slammed with some tax as well. Based on the tax rule, you cannot pay such money back when the hardship period is over.

When you take such a withdrawal, some firms will not allow you to contribute for six months or more, which further adds to what you lose from such retirement savings. 


Situations that Qualify as Hardship Withdrawal 

Here are limited situations that merits the hardship level as specified by Congress:

  • Medical expenses for you, your spouse, or your dependent that were not reimbursed

  • Compulsory payment needed to prevent eviction from your residence 

  • Expenses required for burial or funeral for your spouse, parent, kid, or a dependent

  • Down payment for a principal residence or payment for some major repair of your main house

  • College tuition payment alongside other education costs spanning 12 months for you, kids, dependent and nondependent kids. 

401(k) Loans

Experts argue that 401(k) is a better option than the hardship withdrawal option since it is like borrowing from your savings. However, borrowing is not possible with all plans, so make sure to be sure by asking your employer. In addition, even if such a loan is possible, you need to be mindful of some rules to avoid penalties on withdrawals.

Your employer's plan will typically have the amount you can borrow, but it has a limit of half of the vested account value up until a maximum dollar value. One also has a minimum loan amount, and this information will be available with your employer.

 

Essential things to Note with 401(k)

  • There are plans where you get two loans at once. However, many plans only give room for one, and you must pay it off before you can ask for another.

  • You might need to get permission from your domestic partner or spouse

  • You might be mandated to make periodically scheduled repayment (both interest and principal) through the payroll deductions

  • The duration for the payback is five years, except the borrowing was to buy a primary residence which has a longer repayment period

  • Whatever money you are paying yourself back, will be done with post-tax dollars

While using your 401(k) as a loan is easy and cheap, consider that you will pay yourself back with interest, which cancels any return on investment you could have had should you leave such funds untouched. 


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Pat Raskob
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