When most people contribute to their 401(k) plan, they have every intention of leaving the money in the account until they retire so that the money can grow tax-free and they can build a nice retirement nest egg for themselves. However, sometimes life throws you a curveball and to make ends meet, you’re left trying to take money out of your 401(k) plan. Though sometimes it can feel unavoidable, you need to know the effects of taking the money out of your 401(k) plan before reaching 59 ½-years-old. That way, even if you do qualify to take the distribution, you can budget appropriately for the taxes and penalties you will owe.
Can You Cash Out Your 401(k)?
The IRS permits you to take money out of your plan if you are over 59 ½-years-old, you are disabled or otherwise leave your job or you inherit the 401(k) plan from a decedent and are taking distributions from the account. However, just because you’re allowed to take money out doesn’t mean you won’t have to pay early withdrawal penalties on the taxable portion of the distribution.
Your plan may also offer the ability to take a 401(k) hardship withdrawal in certain circumstances. Each plan can be more specific as to what constitutes a financial hardship, but it always must be for an “immediate and heavy” financial need. For example, a consumer purchase like a new plasma TV or a customized road bike wouldn’t qualify, but a distribution to avoid being evicted from your home when you have no other financial resources would usually qualify.
If your 401(k) plan doesn’t offer the ability to take a 401(k) hardship withdrawal and you don’t meet any of the standard criteria, you aren’t able to tap your 401(k), no matter how severe your need.
Early Withdrawals Defined
If you take money out of your 401(k) plan before turning 59 ½-years-old, you must pay not only any applicable income taxes but also a 10-percent tax penalty on top of those income taxes on the taxable portion of the distribution. For example, if you take out $10,000 from a traditional 401(k), you’ll pay income taxes plus an extra $1,000 early withdrawal penalty unless an exception applies.
For a Roth 401(k), the rules are a little different because you must meet two criteria. First, you must have had the account open for at least five years. Second, you must be either 59 ½-years-old, permanently disabled or taking the distributions as a beneficiary from an inherited account. If you meet both sets of criteria, you get the entire Roth 401(k) distribution out tax-free and penalty-free, including the earnings on all of your contributions.
Tax Rate on Early Withdrawals
Your early 401(k) distributions from a traditional 401(k) plan are treated the same way as qualified distributions for purposes of calculating income taxes, aside from the additional tax penalty. When the money is taken out, it adds to your ordinary income for the year and is taxed at your marginal tax rate. In 2018, after the Tax Cuts and Jobs Act took effect, marginal rates range from 10 percent up to 37 percent. For example, if you take $3,000 out of your 401(k) plan and you’re in the 10-percent tax bracket, that will cost you $300 in federal income taxes. But, if you take that same distribution when you’re in the 37 percent tax bracket, you’ll pay $1,110 in income taxes.
Roth 401(k) early withdrawals are treated differently. Because you didn’t get a tax deduction for your contributions to the account, you don’t have to pay income taxes or the early withdrawal penalty on the portion of your withdrawal that comes from contributions.
But when you’re taking an early distribution from a Roth 401(k) plan, you must prorate your distributions between contributions which aren’t taxable and earnings which are taxable, based on the amount of each in your account. For example, if you’ve contributed $30,000 to your Roth 401(k) and it has grown to $40,000, you have $30,000 of contributions and $10,000 of earnings. Dividing $30,000 by $40,000 shows you that your contributions make up 75 percent of your account balance, so only 10 percent of your early withdrawal is subject to income taxes and early withdrawal penalties. So if you took out $3,000, only $300 would be taxable and subject to the early withdrawal penalty but $2,700 would come out tax-free and penalty-free as a return of contributions.
Early Withdrawal Penalty Exceptions
Even if you’re under 59 ½-years-old when you take a distribution from your account, you might still qualify for an exception that would allow you to avoid the early withdrawal penalty. However, these exceptions only apply to the 10 percent additional tax penalty, not the original income taxes. Also, the tax code doesn’t contain any general exceptions for financial hardships, so even though you might qualify for a hardship withdrawal, you won’t avoid the 10 percent early withdrawal penalty. For example, if you take a hardship withdrawal to pay the rent to avoid being evicted, you will still have to pay the early withdrawal penalty.
If you suffer a total and permanent disability, you can withdraw money from your 401(k) plan without paying an early withdrawal penalty. You can also take money out at any age if you inherited the 401(k) plan and are taking distributions as a beneficiary. If you’re a surviving spouse and you’ve elected to roll the inherited 401(k) plan into your account or retitled it in your name, this exception doesn’t apply.
You can also take money out of your 401(k) plan without penalty under certain government orders. First, if the IRS levies your 401(k) plan to pay for past due taxes, you won’t be penalized when the IRS takes the money out of the account. But if you take the money out and then use it to pay off tax debts, you won’t qualify for the penalty exception. Second, if you’re getting divorced and your 401(k) plan is to be divided between you and your ex-spouse under a Qualified Domestic Relations Order, or QDRO, the distribution to your ex-spouse isn’t subject to the early withdrawal penalty.
If you retire early but are at least 55-years-old when you leave the company, you can take money out of your 401(k) plan without any early withdrawal penalties. If you’re a public safety officer for a state government or subdivision of a state, the minimum age for this exception drops to 50-years-old.
If you are a reservist in the military, you can also qualify for penalty-free early withdrawal if you are called up to active duty. To qualify, you must be called up to active duty for more than 180 days, or for an indefinite period, and the distributions must be made during the time you were on active duty.
Finally, you can also take out money and avoid the early withdrawal penalty if you use the proceeds to pay for medical expenses that are deductible under the itemized medical expenses deduction, even if you don’t claim the deduction. For both the 2017 and 2018 tax years, the threshold is medical expenses in excess of 7.5 percent of your adjusted gross income. For example, if your adjusted gross income is $61,000, your threshold is $4,575. If you have medical expenses totaling $6,575, you can exempt up to $2,000 of your 401(k) withdrawal from the penalty regardless of whether you itemize and claim the medical expenses deduction.
If you were taking an early withdrawal from an IRA, you would also have two additional exceptions: The first-time homebuyer exception and the higher education exception. The first-time homebuyer exception allows you to withdraw up to $10,000 to purchase a first home. The higher education expenses exception allows you to pay for higher education expenses for yourself, your spouse or your children, such as college tuition and room and board. However, the early withdrawal penalties do not apply to distributions from a 401(k) plan.
401(k) Hardship Loan
Your 401(k) plan might also offer you the option to take a loan from your account rather than taking an early distribution, but 401(k) plans aren’t required to offer a loan option, so not every plan allows loans. Check with your 401(k) plan administrator to determine if a loan from your plan is an option.
If your plan does allow loans, the maximum you can borrow is the smaller of $50,000 or half of your vested account balance. For example, if your vested account balance is $68,000, you can borrow up to $34,000. But, if your vested 401(k) plan balance is $188,000, you can’t borrow more than $50,000.
The vested account balance refers to the amount of money you could take with you if you left the company today. You are always fully vested in the contributions you make to your 401(k) plan, but if you haven’t worked at your company for at least six years, you might not be fully vested in all or a portion of the account. For example, some companies will fully vest you after three years, but you’re not vested at all in the company’s contributions until then. Other companies will vest you 20 percent after the second year, and then an additional 20 percent each year after that until you’re fully vested after six years.
Generally, you must repay your 401(k) loan through payroll deductions, with interest, over no more than five years. The good news is that the interest you pay goes back into your 401(k) account, but the bad news is that you miss out on any investment gains while the money was loaned to you rather than being invested in the market. Plus, if you don’t repay the loan as agreed, any outstanding balance is treated as a distribution and subject to income taxes and early withdrawal penalties.
No Rollovers for Loans and Hardship Distributions
Many distributions from your 401(k) plan can be rolled over into another qualifying retirement account such as another 401(k) or an IRA within 60 days so that the money isn’t treated as a permanent distribution. For example, if you leave your old job and cash out, but your new job also offers a 401(k), and you redeposit the money within 60 days, you won’t pay taxes on the distribution, and it will continue to grow tax-free in the new company’s 401(k) plan. Or, if your new company doesn’t have a 401(k) plan, you can roll the money into an IRA that you start on your own to hold the money with the same result. However, if you take a hardship distribution, or if you default on your 401(k) loan and it becomes treated as a permanent distribution, you can’t roll over those amounts.
No Changes from 2017 to 2018
The rules for what constitutes an early withdrawal from a 401(k) plan, and the penalties and exceptions to the penalties, haven't changed from 2017 to 2018.
- Retirement Topics - Hardship Distributions
- IRS: Retirement Plans FAQs regarding Loans
- IRS: Roth Comparison Chart
- IRS: 401(k) Resource Guide - Plan Participants - General Distribution Rules
- IRS: Retirement Topics - Exceptions to Tax on Early Distributions
- Legal Information Institute: 26 USC 72
- Legal Information Institute: 26 USC 213