How to get around the 401(k) early withdrawal penalty
Technically, you’re not supposed to touch the money in your 401(k) until you’re at least 59 1/2—and for good reason. Unless you’re in dire straits, it’ll cost you.
The IRS charges a 20% tax withholding and a 10% penalty for early withdrawals. Plus, if you spend the money in your 401(k), it’s no longer there for you in retirement. That said, there are some ways to access your savings before age 59 1/2 without paying a penalty. (You’ll still be taxed.) But read the fine print, and tread carefully. Remember: This is your nest egg we’re dealing with.
Key Points
- Early withdrawals from a 401(k) can be costly in terms of taxes and a penalty—plus, you’re losing your retirement nest egg.
- “Hardship” withdrawals include medical bills, a down payment on a home, funeral expenses, and some others.
- You can also access your 401(k) penalty free if you retire early (but restrictions apply).
What an early 401(k) withdrawal might cost you
You know how a new car loses a chunk of its value the minute you drive it off the lot? It’s similar when you take an early withdrawal from your 401(k). The amount you planned to get shrinks—by a lot:
- Taxes. First, the IRS withholds 20% of your withdrawal amount to cover your tax bill. Why? Because the money you originally contributed to your 401(k) was pre-tax. So your savings are tax deferred, but not tax free (sorry), which means you still have to pay Uncle Sam his due, no matter when you withdraw the money.
- Penalty. Unless you’re covered by one of the situations described below, the IRS will also tack on a 10% penalty. So a $20,000 withdrawal would become $14,000 in hand (minus $4,000 for taxes; $2,000 for the penalty).
- Lost earnings. The third cost is less visible, but no less substantial. If you dip into your nest egg now, there’s less in your account to grow in the years to come. So you’re not only depleting your retirement savings, but you’re also losing the potential earnings on that money.
But if you must, you must. So if you can find a way to sidestep the 10% zinger, that’s at least some consolation.
Exceptions to the early withdrawal penalty
If you become or already are permanently disabled, you would still owe taxes on an early withdrawal, but you likely wouldn’t owe a penalty.
If you die and your beneficiary inherits the 401(k) funds, those distributions would be taxed, but the beneficiary wouldn’t owe the 10% penalty.
These are the simple, logical exceptions. But, assuming your 401(k) plan allows early withdrawals (not all do, so please check), there are other circumstances under which you may take an early withdrawal and pay the tax, but avoid getting hit with the additional 10% penalty. Let’s start with so-called “hardship” withdrawals.
What qualifies as a 401(k) hardship withdrawal?
Different 401(k) plans may have different rules, so again, check with your plan administrator about whether you qualify for a hardship withdrawal. But the IRS defines it as “an immediate and heavy financial need.” Here are some examples:
- COVID-19-related expenses, as defined under the CARES Act (for 2020 only)
- Funds to avoid foreclosure or eviction from a primary residence
- Funeral expenses
- Certain home repair costs
- Medical bills for you, your spouse, dependents, or beneficiaries
- Money to buy a primary residence (for a down payment, not mortgage payments)
- College tuition for you, your spouse, dependents, or beneficiaries
Before you can qualify under one of these conditions, you’ll need to prove that you can’t get the money any other way, and you won’t qualify for more than the hardship amount.
Other penalty-free withdrawal options
If you don’t meet the criteria for a hardship withdrawal, there are some other ways you might be able to avoid paying that extra 10%. In all of the cases listed below, the restrictions can be complicated, so make sure you qualify:
- If you leave your job the year you turn 55 or older, you can start taking withdrawals from your 401(k) without paying a penalty. Certain public safety workers can start at age 50. Learn more about the Rule of 55 here.
- A complicated arrangement called Substantially Equal Periodic Payments (SEPP)—also known as a 72(t) distribution—may enable you to start taking regular, annual withdrawals from a previous 401(k) plan (not your current one), penalty free.
- If you gave birth to a child or adopted a child during the year (up to $5,000 per account).
- If you rolled over the account to another plan, within a certain time.
- If your account is divided owing to a Qualified Domestic Relations Order (typically because of a divorce).
- If you made automatic 401(k) contributions and want to reverse them (within 90 days).
- If you received qualified withdrawals as a military reservist called to active duty.
This is not an exhaustive list, so if you believe your situation may allow you to avoid a penalty, it’s a good idea to inquire. For a full list, visit the IRS “exceptions to tax on early distributions” page.
The bottom line
Life happens, but tapping your 401(k) is not the only solution. You can consider a 401(k) loan, where you wouldn’t owe taxes or pay a penalty. But 401(k) loans come with stringent repayment terms.
Personal loans or home equity loans and lines of credit might also be feasible options. But you have to consider the long-term repayment costs of taking on debt. The most important thing is to explore all your options and minimize the price you pay now—and the cost to you in the future.