If you're under 59 1/2, you can only withdraw money from your 401(k) plan after you've left your job or you have a substantial financial hardship. Even if you're eligible, before you cash out some of your nest egg make sure it's absolutely necessary because of the substantial tax implications of an early withdrawal.
Any money you withdrawal from your 401(k) is subject to income taxes and can push you into a higher tax bracket, while early withdrawals can also incur a 10 percent penalty.
Income Taxes on Withdrawals
When you take out money from your 401(k), you have to count the withdrawal as taxable income in the year that you take it out. As a result, it gets taxed at your marginal tax rate. Worse, if you take out enough, you could push yourself into a higher tax bracket.
For example, say you're in the 12 percent tax bracket, but you take out $20,000 from your 401(k) and that pushes you $15,000 into the 22 percent tax bracket. You pay the 12 percent rate on your first $5,000 and 22 percent on your last $15,000.
Tax Penalties on Early Withdrawals
The IRS hits you with an extra 10 percent penalty on top of the income taxes on your withdrawals taken before age 59 1/2. The early withdrawal penalty adds to the amount you owe when you file your tax return for the year.
For example, if you take out $20,000, not only will you owe income taxes, but you also owe $2,000 in tax penalties. So, if you were anticipating a $1,500 refund, you'll instead be stuck paying $500.
Exceptions to the Penalty
In some cases, you can avoid the extra 10 percent tax penalty on your early withdrawals. To do so, you must qualify for one of the specific exceptions – not just have a general financial hardship. If you suffer a permanent disability or are taking a qualified reservist distribution, your entire withdrawal comes out penalty-free. The IRS also exempts distributions taken as a result of an IRS levy on the 401(k) plan or qualified domestic relations order, or to the extent you have deductible medical expenses from the penalty. However, no exception gets you out of paying the income taxes.
No Makeup Contributions
When you take out your money from your 401(k) plan, you don't get to contribute extra in future years to make up for the withdrawal. Though it's not as obvious or tangible as the extra tax penalty that you pay when taking out your money, it can be just as costly. For example, if you take out $10,000 from your 401(k) when you're 25, that's $10,000 that won't grow tax-sheltered for several decades before you retire.