Early Withdrawal From Your 401(k)

It is only natural to worry about the financial pressures brought on by retirement, and for many, the 401(k) plan can seem like a godsend. The employer-sponsored plan helps workers by allowing them to defer income to their retirement account on a pre-tax basis, often while enjoying an employer match in the bargain. Small wonder, then, that as of September 30, 2022, 22.6% of American retirement assets were comprised of $8.9 trillion of retirement assets in defined contribution plans such as the 401(k).

One of the greatest advantages of a 401(k) is the employer match. This refers to the money your company contributes to the retirement account. Each company has different matching rules; however, any matching amount is free money.

For 2022, the most an employee can contribute to a 401(k) is $20,500 ($22,500 in 2023). Employees 50 or older are permitted to make an additional $6,500 in contributions for 2022 and $7,500 in 2023.

Key Takeaways

  • Many employees have 401(k) retirement plans, which allow for tax-deferred growth and employer matches on contributions.
  • If you withdraw your 401(k) money before age 59½, you will be subject to a 10% penalty and must pay any deferred taxes on that money.
  • Retirement savers in some cases can withdraw 401(k) money without penalty to pay for certain expenses such as a first home or education.

Early Withdrawal Penalties

There is a catch, however. If you begin taking funds out before you reach the age of 59½, you may face a 10% penalty and owe any deferred taxes that haven't yet been paid. Early withdrawals are typically a sub-optimal decision because of the stiff penalties savers face.

A person is also required to start withdrawing money from a 401(k) by April 1 of the year after they turn 72 (or 73 starting in 2023), or else they will face a penalty. These withdrawals are referred to as required minimum distributions (RMDs).

Millions of people rely on this nest egg to help them through their retirement years. But what if real-life needs intrude—such as mortgage payments, a child's college education, or credit card debts—and the holder must withdraw funds from their 401(k)? Investment experts generally frown on early withdrawals, but is there ever a time when it is wise to take money out of this tax-free investment?

Dealing With Debt

While every investor is different, financial professionals point out that many people find themselves in similar situations.

Carol Hoffman, a principal advisor with Clear Perspectives Financial Planning in Cincinnati, Ohio, cites an example of someone who should "possibly withdraw" funds from a 401(k). Hoffman's client is married, and her husband is employed with a retirement plan. She has a pension of her own of about $6,000 a month and a 401(k) containing $60,000.

What makes the client's situation compelling is that she is leaving her employer at a time when she and her husband are facing a daunting financial challenge. This couple has incurred "significant debt." It relates largely to the expense involved in sending their three children to college as well as the $25,000 they have racked up in credit card debt.

"We recommended this client withdraw the full 401(k) and pay down debt," Hoffman says. The client did not know the IRS allows the withdrawal of the 401(k) at age 55 after the termination of employment.

Hoffman has another bit of caution to offer: "People who run up a lot of debt at once tend to do it repeatedly, so we can only recommend this strategy if we are working with them to plan their spending and increase their savings. We cut up their credit cards."

Losing Out on a 401(k)

People who don't maintain their 401(k) plan may wind up regretting the neglect. Just before he turned 60, the respected New York Times business columnist Joe Nocera publicly lamented his predicament in an April 2012 piece when he took stock of his life: "The only thing I haven’t dealt with on my to-do checklist is retirement planning," he wrote. "I don’t plan to retire. More accurately, I can’t afford to retire. My 401(k) plan, which was supposed to take care of my retirement, is in tatters."

Unforeseen circumstances, such as divorce and the bursting of the dotcom bubble in 2000, worked to cut Nocera's 401(k) in half twice.

IRA Rollover

Some investors want to have an alternative to a 401(k) while realizing the tax savings. Transferring funds from a 401(k) to an individual retirement account (IRA), in what's known as an IRA rollover, offers tax benefits, too.

Hildy Richelson, president of the Scarsdale Investment Group in New York, says: "Individuals should roll their 401(k) into a self-directed IRA and purchase high-quality, individual bonds to fund their retirement, then they are able to self-manage their retirement assets."

Phillip Christenson, a chartered financial analyst and the co-owner of Phillip James Financial, says: "If you are no longer with your employer but your 401(k) was never moved, you should consider rolling the assets over to another qualified account such as an IRA. You will probably have many more investment options and potentially lower-cost options than your old 401(k) plan offer."

At the same time, Christenson cautions investors that "in some cases, your 401(k) plan may have an investment that you won’t have access to outside of your plan, such as a Guaranteed Principal Account." Christenson adds that "especially in this low-rate environment, I have seen these types of funds offer attractive rates with no loss of principal."

The Risks of a Rollover

Before people roll over their 401(k) funds to an IRA, however, they should consider the potential consequences. "Consider the costs inside the 401(k) funds versus the total cost of an IRA," including advisor fees and commissions, urges Terry Prather, a financial planner in Evansville, Ind.

Prather raises another, noteworthy scenario. A 401(k) typically requires a spouse to be named as the primary beneficiary of a particular account unless the spouse signs a waiver provided by the plan administrator. An IRA doesn't require spousal consent to name someone other than the spouse as the primary beneficiary.

"If a participant is planning to remarry soon and wants to name someone other than the new spouse as the beneficiary—children from a prior marriage, perhaps—a direct rollover to an IRA may be desirable," Prather says.

Exhausting All Other Options

Investment advisors emphasize that people should exit a 401(k) only when they deem it absolutely necessary and have exhausted all other options. Remember, the 401(k) is above all a retirement account. It is wise to consult an investment professional before taking such a dramatic course of action.

"Many employees, as they are exiting their employment through retirement or a job change, rightly seek out advice from financial professionals," noted Wayne Titus III, who is managing director at Savant Wealth Management in Plymouth, Michigan. "These may include a range of professions, from insurance agents, brokers, tax preparers, or CPAs."

What Happens if You Withdraw Your 401(k) Money Early?

If you withdraw 401(k) money early, before 59½, you will be charged a 10% penalty. You will also have to pay income tax on the amount withdrawn. There are some qualified scenarios in which you can withdraw early and will not be penalized.

What Reasons Can You Withdraw From Your 401(k) Without Penalty?

Withdrawing from your 401(k) early (before age 59½) will incur a 10% penalty. The IRS allows for certain situations, known as hardship withdrawals, that will allow you to withdraw early without penalty. These reasons include becoming disabled or otherwise not being able to work, medical expenses, costs related to the purchase of a primary residence, educational fees, funeral expenses, payments to prevent eviction or foreclosure, and certain damages to one's home.

How Much Can I Contribute to My 401(k)?

For 2022, individuals can contribute up to $20,500 to their 401(k) with a $6,500 catch-up contribution limit if they are 50 or older. For 2023, these amounts are $22,500 and $7,500, respectively.

The Bottom Line

Experts point out that a 401(k) that is totally invested in stocks can expect to yield an annual return of about 9% to 10%. Since 1957, the S&P 500 Index has returned roughly 10% annually before inflation. Experts stress that alternative investments may provide larger short-term returns. But a 401(k) should be regarded as a safe haven at all costs. Risk should not be part of the investing equation here.

Article Sources
Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts. We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in our editorial policy.
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  2. Internal Revenue Service. "Topic No. 424 401(k) Plans."

  3. Internal Revenue Service. "401(k) Limit Increases to $22,500, IRA Limit Rises to $6,500."

  4. Internal Revenue Service. "Topic No. 558 Additional Tax on Early Distributions From Retirement Plans Other Than IRAs."

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  6. Internal Revenue Service. "Retirement Plan and IRA Required Minimum Distributions FAQs."

  7. The New York Times. "My Faith-Based Retirement."

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  11. Internal Revenue Service. "Retirement Topics - Hardship Distributions."

  12. Official Data Foundation. "Stock Market Returns Since 1957."

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