What Are the Penalties for Cashing Out a 401(k)?
What are the penalties for cashing out a 401(k) before retirement? Knowing ahead of time can save you from a big mess. However, there are exceptions to help you avoid penalties.
A 401(k) is a tax-deferred retirement savings account. The IRS incentivizes saving for retirement by relieving the immediate tax obligations for your distributions during retirement. But what are the penalties for cashing out a 401(k) before you’re eligible?
The IRS issues a 10% tax penalty for cashing out funds from a 401(k) without meeting their criteria to do so. You can avoid the 10% penalty by qualifying for hardship withdrawals, through substantially equal periodic payments, and distributions made if you’ve left your job after 55.
It may be tempting to withdraw your 401(k) funds when faced with a considerable expense. With no other options, it’s easy to view your retirement savings as a glorified savings account or emergency fund.
However, tapping into your 401(k) before retirement could leave you with a big mess on your hands.
Repercussions of an Early 401(k) Withdrawal
The IRS sets the rules around retirement savings. There are limits to how much tax-deferred income you can deposit into different retirement accounts per year, what accounts you can put pre-tax dollars in, what accounts you can put after-tax dollars in, even when you can access your money.
Fail to follow these rules, and you could face huge penalties and other expected costs.
You’ll Be Assessed a 10% Penalty
First, the IRS will issue a 10% penalty immediately upon withdrawal of any funds taken out before turning 59½.
This penalty is taken out immediately from the amount you withdraw from your 401(k).
Say you take out $10,000 from your employer-sponsored 401(k). You speak to your HR department or your plan administrator and take all of the necessary steps. By the time the money reaches you, you’ll only have $9,000.
The IRS implements this penalty to make you think twice about shorting your retirement too early.
You’ll Face a Hefty Tax Bill
On top of the 10% penalty, you’ll owe taxes on the amount you withdraw from your 401(k).
Your plan administrator is required to withhold 20% of your withdrawal for taxes. However, depending on your income bracket, this may not cover your entire tax obligation.
If you’re unable to come with the rest when you file taxes, you may be left with more costly options to pay the remaining taxes.
You May Have Less For Retirement
It’s no secret the winning formula for a well-funded retirement is time and consistency. When you withdraw early from your 401(k), you’re eliminating the time it has to grow from compounding interest.
Even if you intend to replace the money later, it will still miss out on any growth opportunities until you restock your account.
If you withdrew from your 401(k) during a dip in the market, you could miss growth from the market rebounding.
When it comes to money, there are always opportunity costs. When taking money out of your 401(k) early, this could cost you much more money than taxes and penalties.
How Can I Avoid Penalties for Cashing Out a 401(k)?
Life happens. And believe it not, the IRS understands this. They have instituted several exceptions that waive penalties. You will, however, still need to pay taxes on the funds you withdraw in most cases.
- Avoid the 10% Penalty
- “Substantially Equal Periodic” payments. The IRS allows you to withdraw money from your 401(k) if you agree to take a series of equal distributions (at least once annually) from your account. You must commit to this plan for at least five years or until you’re 59½, whichever is longer.
- If you leave your job after you turn 55, you can withdraw from your 401(k) penalty-free. Again, you’ll still be subject to taxes, but the 10% penalty will not apply.
Federal law enforcement professionals, federal firefighters, customs and border patrol agents, or air traffic control workers can withdraw after age 50 penalty-free.
- Court proceedings from a divorce may entitle you to penalty forgiveness if you’re required to split your 401(k) balance with your ex-spouse.
- Become or are disabled.
- Have or adopt a child. You may be able to withdraw from your 401(k) up to $5,000 and avoid any penalty.
- Victims of a disaster may have this penalty forgiven. Most notably, the CARES Act of 2020 waived this penalty for withdrawals due to hardship from the COVID-19 pandemic. It’s worth noting to pay close attention to current legislation for any changes to the guidelines. Lapses and new relief packages associated with COVID-19 can cause withdrawals to fall outside of these protections.
- Military reserve members who are called to active duty can withdrawal their 401(k) funds penalty-free to aid in the loss of income.
- Qualify for Hardship Withdrawal
- Medical bills that exceed 10% of your adjusted gross income can avoid withdrawal penalties. This forgiveness extends to any medical procedure required for you, your spouse, and any dependents.
- Money used to buy a house can come from your 401(k) without paying the penalty. However, this only includes the upfront costs of purchasing the home, not any subsequent mortgage payments.
- Costs associated with higher education such as tuition, fees, and room and board can be covered with funds from your 401(k) penalty-free. Like medical bills, this includes costs you incur as well as your spouse and dependents.
- To avoid foreclosure or eviction. Withdrawing funds from your 401(k) to avoid losing your home is not subject to a penalty. Remember, however, taxes will still be due, so keep this in mind to avoid a bigger mess in the future.
- Funeral expenses for a parent, spouse, or dependent can be covered penalty-free using a 401(k).
- Transfer to an IRA
Being approved for a hardship withdrawal by your employer isn’t always guaranteed. For instance, you won’t be eligible if you have other assets you could use instead of your 401(k).
If your goal is to purchase a home or pay for college expenses you may have yet another option.
The IRS allows you to use funds from a traditional IRA to cover college expenses or to purchase your first home (up to $10,000 of your funds) without penalty.
By transferring funds from your 401(k) to a traditional IRA, you can tap into your retirement money for those reasons. You’ll still be required to pay income tax on the amount, but you’ll avoid the extra 10% penalty if you withdrew straight from your 401(k).
At Beagle, we can help track down your 401(k)’s, even from previous employers, and consolidate them into a single, convenient IRA. We’ll even find any hidden fees you may be paying with your current plan to help save you even more money. Sign-up takes only minutes and is completely free.
- Opt for a 401(k) Loan Instead
Another option for accessing your 401(k) funds is by taking a loan out against your account. Your plan’s administrator will set the terms and rate of the loan; however, you will avoid penalties and taxes as you are required to repay the money.
The interest you pay goes into your 401(k), so it won’t cost you any money; in fact, it helps build your 401(k) back up.
If you lose your job or default on the loan, you’ll be required to pay taxes and penalties on the loan.
Your 401(k) administrator will determine the length of the loan term. Although, legislation surrounding the COVID-19 pandemic allows for an additional year to all 401(k) loans. Again, check with your plan to get the latest guidelines.
- Withdraw the Minimum Amount You Need
Although you’ll still incur the 10% penalty and the tax burden, limiting the amount you withdraw from your 401(k) will keep these costs low.
Before taking money out of your 401(k) early, calculate the bare minimum you need to cover whatever situation you find yourself in.
By not taking more than you need, you’ll eliminate paying tax and penalties on the amount you don’t need at the moment. Additionally, the amount you leave will continue to grow along with the rest of your retirement savings.
Things to Remember
Your retirement funds and the rules surrounding them help to ensure you’ll have enough money throughout retirement.
Taking money out too early can have detrimental effects on the amount you’ll have to live off of throughout retirement.
However, for instances where it’s critical to gain access to your retirement funds early, you have options. You can avoid penalties if you meet the criteria mentioned earlier or go other routes to bypass specific rules.
Consult your plan’s administrator or a financial professional for the best options for your situation.