How to Avoid the 401k Penalty for Early Withdrawal

Are you finding yourself in dire need of cash? Do you have a sizable amount saved in your 401k retirement plan?

You may be tempted to tap the funds in the 401k to pay off bills or make a big purchase, such as your kid’s tuition or home improvements.

However, that’s rarely a good idea, in part because of a costly penalty imposed by the IRS on early withdrawals.

401k plans come with restrictions. You’re generally not allowed to withdraw from your 401k until age 59 ½ without penalty. Because 401k plans are designed to aid in saving for retirement, they discourage early withdrawals.

In this article, we’ll examine the 401k early withdrawal penalty and offer some options for people who may be considering raiding their plans early to access much-needed cash.

The Basics of the 401k Penalty

The IRS discourages withdrawals from 401k plans until the account holder is 59 ½.

Anyone who withdraws money from their 401k prior to that age will have to pay federal and state income taxes on the amount withdrawn, plus a 10 percent early withdrawal penalty. This can add up to a sizable sum.

Let’s examine the impact of the penalty on someone who might choose to make an early withdrawal.

Joe has a car that keeps breaking down, so he decides to withdraw $20,000 from his 401k plan to pay for a new one. Because Joe has a fairly high salary, he is in the 32 percent federal tax bracket.

Let’s assume for this example he doesn’t have to pay state taxes. This withdrawal will result in a federal tax payment of $6,400. On top of that, he’ll have to pay the 10 percent penalty ($2,000). The total tax bill is $8,400.

The extra $2,000 may not seem like much, but it can represent a large amount when you consider that it could have otherwise been used to invest and grow retirement savings.

Even $2,000 could be worth more than $15,000 in 30 years based on good market returns.

And it’s easy to imagine the negative impact from a larger early withdrawal or multiple early withdrawals over time.

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How Withdrawing Early Impacts Long-Term Savings

The most impactful downside of withdrawing funds from a 401k early may not be the penalty itself but the reduction in the amount of money that could grow over time.

Every dollar you remove from a retirement account represents a dollar that can’t be invested.

Consider someone who currently has $100,000 saved in a 401k and is contributing $1,000 per month. Assuming a modest 7 percent annual return, this person will have nearly $2 million saved in 30 years.

But let’s say this same person removes $25,000 from their 401k to pay off a car. Now, they only have $75,000 to start.

Over 30 years and with the same $1,000 monthly contribution, this person will have just under $1.8 million. Thus, a one-time withdrawal of $25,000 actually cost the investor nearly $200,000.

Exceptions to the 10 Percent Penalty

There are times when the IRS will waive the 10 percent penalty for early 401k withdrawals.

The Hardship Exception

The IRS will waive the 10 percent penalty under the hardship exception if you can prove you have an “immediate and heavy” financial need. Things that match this criteria, according to the IRS, include:

• Medical care
• Tuition expenses
• Buying a first home
• Payments to avoid foreclosure or eviction
• Some expenses for home repairs
• Funeral expenses.

These are broad exceptions, and there are specific rules governing each one. Medical expenses, for example, are only eligible if unreimbursed costs make up more than 7.5 percent of your adjusted gross income.

The IRS specifically notes that consumer goods such as a boat or television would not qualify as a hardship distribution.

It also says that to qualify for the hardship exception, you must prove that you couldn’t have gotten the funds you need through other means, such as from insurance or loans.

It is also important to note that hardship withdrawals are limited to your personal contributions to the 401k plan. You can’t withdraw any gains the funds have earned or any contributions from employers.

And this information comes with the same warning we mentioned above — any reduction in your 401k can drastically reduce the amount of money that can be invested and ultimately saved overall.

Age and Other Exceptions

For most people, 59 ½ is the magic age at which they can withdraw money from a 401k without penalty. But there are some exceptions.

If you have a 401k plan through an employer and leave that company between ages 55 and 59 ½, you may withdraw money from your plan without penalty.

Public safety employees, such as police officers and firefighters, may withdraw money penalty-free as soon as age 50.

(In 2015, this was expanded to include federal law enforcement officers, customs and border protection officers, federal firefighters, and air traffic controllers.)

There are other people who may be exempt from the penalty, such as military reservists in some situations, or anyone who is required to pay money from their 401k as part of a divorce settlement.

Also, if the IRS seeks money from your 401k due to a tax lien, those withdrawals are not penalized.

The Rollover Exception

There are some instances in which it makes sense to roll over a 401k plan into an IRA.

If you leave a company and no longer have access to the 401k plan, converting to an IRA may be a good move because IRAs often have lower fees and more investment options.

Technically, when you convert money from a 401k to a traditional IRA before age 59 ½ you are making an early withdrawal. But the IRS allows investors to make this switch without penalty.

Note: If you convert a 401k to a Roth IRA, there is no penalty, but you’ll have to pay tax on all of the gains at the time of the conversion.

Once money is in an IRA, you’re permitted to receive “substantially equal periodic payments” (SEPPs) for five years or until you turn age 59 ½ (whichever is longer.)

This process can be quite complicated, so it’s best to read the FAQs about SEPPs on the IRS site.

Alternatives to 401k Early Withdrawals

There are ways to avoid having to take early 401k withdrawals. Some of these options require foresight, but others are alternatives that may make sense at the time you need the money.

401k Loan

You can avoid the 401k tax penalty by borrowing from your balance rather than withdrawing. You can borrow up to half of your vested account balance, with a maximum of $50,000 allowed.

All 401k loans must be paid back within five years unless the loan is used to buy your first home. Payments on the loan must be made in “substantially equal” installments on a least a quarterly basis over the life of the loan.

While borrowing from a 401k plan is not the smartest financial move, it is better than simply withdrawing and incurring the 10 percent penalty.

Emergency Fund

The easiest way to avoid early withdrawal from your 401k — and the tax penalty that goes with it — is to have enough cash savings elsewhere.

Even people with high incomes sometimes fail to leave enough easily accessible cash to pay for unexpected expenses like a medical emergency, or major car or home repairs.

There are varying opinions as to the ideal size of an emergency fund, but it’s widely believed that you should have at least six months of expenses saved in cash.

That may be enough so that you can easily handle most emergencies without tapping investments or going into debt. If you’ve got a higher income, try to set aside at up to a years’ worth of expenses.

Consider directing a certain amount of money into a special emergency savings account so that you aren’t tempted to spend it.

Other Income Sources

Many people who take early withdrawals from their 401k plans do so because they’ve experienced a sudden loss of income, perhaps due to a job loss.

It can certainly be jarring to find yourself going from a comfortable salary to no income at all. That’s why it makes sense to try to earn income from a variety of sources aside from your primary job.

It helps to have a “side hustle” that earns you some extra money, so that you never see your income drop to zero if you suddenly find yourself unemployed.

Perhaps you can do freelance work on the side, or make crafts and sell them online. Maybe you can moonlight as a fitness instructor, a math tutor or Uber driver.

You can also generate passive income streams from stock dividends or rental properties, or earn royalties from copyrighted work.

Whatever it is, this extra income can help you through a financial rough patch and reduce the likelihood that you will need to make an early withdrawal from your 401k to get by.

Roth IRA

Taking out money from a retirement fund is never the best idea because you lose the potential for future earnings. But if you see no other options, you can take out money from a Roth IRA without incurring penalties or paying taxes.

If you have a Roth IRA account, you are permitted to withdraw the contributions (not the gains) prior to retirement age without penalty. So, if you’ve contributed $50,000 to a Roth IRA over the years, that money is available to you at any time.

Keep in mind, however, that any time you remove money from a retirement account, you are costing yourself potential future earnings.

Home Equity Loan or Home Equity Line of Credit

A home equity loan (HEL) or home equity line of credit (HELOC) could be a smarter way to get cash for your large purchase.

Common sense financial planning would generally not endorse taking on new debt, but it may be better in the long run than withdrawing money from a 401k plan.

That’s because, over time, the returns on the stock market are usually higher than the interest rates on home equity loans.

As long as you are in a position to pay back loans and get a favorable interest rate, it’s better to consider borrowing from a bank than from your future self in the form of a 401k withdrawal or loan.

HELs and HELOCs are loans that use your home equity for collateral. Because they’re secured by your house, they tend to have low interest rates.

Currently, home equity lines of credit come with variable interest rates of about 5 percent, and the fixed rates for home equity loans are slightly higher. Both are lower than stock market returns in a typical year.

When you factor in the 10 percent tax penalty and the potential loss of capital gains incurred by withdrawing from a 401k, many people would be better off getting a home equity line of credit or loan.

Keep in mind, however, that interest rates have been on the rise and market returns have been volatile. So there is some risk to using a HELOC for your purchase.

Cash-Out Refinance of Your Home

This is a little trickier to pull off now that interest rates have been rising, but you may be able to do a cash-out refinance to get the money you need.

With a cash-out refinance, you get a new mortgage that’s more than your current mortgage. The difference goes to you in cash.

In essence, what happens in this situation is that you change the terms of your loan and upon closing, you get a check. The amount of that check is added to the balance of the refinanced loan.

The refinancing of your mortgage may save you money in the long run, especially if you are able to shorten the term of your loan and pay a lower interest rate.

On the flipside, it may cost you significant money if you extend the loan term (For example, switching from a 15-year to 30-year mortgage.) But in many cases, it is better to pursue this route than take money from your 401k.

Tip: If you go this route, check out the best mortgage refinance companies.

0% Interest Rate Credit Card

There are many credit cards that offer a 0% interest rate for new card users with the understanding that you will begin paying interest at a later date. Some cards charge no interest for 18 months or even longer.

Thus, using a credit card to pay for large purchases could be better than raiding your 401k savings.

There is some risk to this approach, as using credit cards can potentially lead to an increase in debt.

The results could be financially damaging if you pay interest on your balances. But if you are responsible and use the card smartly, it beats an early 401k withdrawal every time.

Summary

You should only withdraw from your 401k as a last resort. Doing so not only robs your future self of retirement funds but also subjects your current self to taxes on the amount you borrow, plus a 10 percent penalty.

There are plenty of alternatives to this approach that you should think about first. Most are cheaper and will leave you better situated for the future than withdrawing from your 401k.