401(k) Loan vs. IRA Withdrawal: An Overview
Dipping into a retirement account early is rarely an investor's Plan A, but there could come a time when an individual sorely needs cash and has no other options. Under certain circumstances, drawing on a 401(k) or individual retirement account (IRA) might be your only real choice.
Unfortunately, the IRS doesn't make it easy to tap these tax-advantaged accounts. Typically, you’ll be assessed a 10% penalty on any funds withdrawn out of a traditional 401(k) or IRA account before the age of 59½. The penalty is on top of the ordinary income tax rate you normally pay on distributions.
However, the IRS and many retirement plans allow for hardship withdrawals, which are distributions from an IRA or 401(k) that avoid the 10% penalty. These exceptions to premature withdrawals before the age of 59½ include funds for medical expenses and if the IRA owner suffers total and permanent disability.
Granted, the decision to use this money for something other than your retirement shouldn’t be taken lightly. But if you can get around the IRS penalty, the idea starts to make a little more sense.
- Withdrawing money early from a 401(k) or IRA will result in an additional 10% penalty. There are few exceptions to this rule.
- You can borrow from your 401(k) account and pay back the money over five years.
- You can withdraw money early from an IRA without penalty for a few specific reasons, such as placing a down payment on a first home or paying for college tuition.
Sometimes It Pays to Borrow From Your 401(k)
For many workers, this is probably the easiest way to access retirement money early. Some plans allow you to borrow from your 401(k) for a wide variety of reasons.
With a 401(k) loan, you can withdraw the lesser of $50,000 or half the vested balance in your account. You then repay your account over a period of up to five years. Some employers allow a longer period if you borrowed to buy a home. Some plans allow the borrower to reimburse the account early with no pre-payment penalty.
It’s worth noting that you typically pay back a little more than you took out of the account. This "interest" actually works to the borrower's advantage. Because the funds go into your account, you’re essentially making up for some of the interest or capital gains the money would have accrued had you not withdrawn it from the fund. Most 401(k) plan providers and platforms will charge fees to process and service a loan. This adds to the cost of borrowing and repayment.
Not all employers offer these loans. Your odds of getting one are better if you work for a large company.
Traditional IRA accounts don’t allow loans, but they do come with certain perks 401(k)s don't offer. The government offers penalty-free IRA distributions, for example, for those who want to further their education or buy their first home.
The tuition exemption applies to individuals who use retirement money to pay tuition at an IRS-approved college, as well as for books and supplies. If you take enough credits, you also can use the funds for room and board without penalty. You even can use the distribution to pay education expenses for your spouse, child, or grandchild without worrying about the extra 10% hit.
Additionally, the tax code allows you to use $10,000 of IRA funds to pay for a first home. If your spouse also has an individual retirement account, that means you can access up to $20,000 for a down payment and closing costs.
You may also withdraw up to $5,000 without penalty to deal with a birth or adoption under the terms of the SECURE Act of 2019.
Unlike a 401(k) loan, there’s no requirement to repay your account.
One of the lesser-known ways to access a traditional IRA is by setting up substantially equal periodic payments (SEPPs), allowing you to make one or more withdrawals a year for either a five-year period or until you reach age 59½, whichever is longer. While SEPPs allow you to avoid the 10% early withdrawal penalty, you're still responsible for paying your ordinary income tax rate on the distributions.