Any amount withdrawn from your 401(k) account must be treated as ordinary income for the year in which the money is taken out.

Key Takeaways

  • Early withdrawals from an IRA—meaning money withdrawn prior to the participant turning 59-1/2), are subject to a 10% early withdrawal and a tax payment due in the filing year.
  • There are some exceptions to the 10% rule, such as for first-time homebuyers and for people with medical emergencies.
  • In 2020, there is a temporary waiving of the 10% early withdrawal fee, because of the passage of the CARES Act, meant to provide relief during the COVID-19 pandemic.
  • Under the CARES Act, a participant can withdraw up to $100,000 from qualifying retirement accounts and pay no early withdrawal penalty, avoid the automatic 20% tax withholding, and take up to three years to pay the taxes due.
  • Money borrowed from an IRA normally needs to be returned within 60 days, but as of the CARES Act, it can be returned within three years.

Exceptions to the Rules

There are exceptions to the rules on early withdrawals from retirement plans. The IRS allows them in certain very specific cases. This is not a break on the income tax owed. It's a break on the penalty.

For example, first-time homebuyers and people who have huge unreimbursed medical expenses may be eligible, depending on the type of retirement plan they participate in.

You may also be eligible to take a loan from your own account, in certain cases.

Any money you take from a 401(k) plan must be reported as ordinary income in the same year that you made the withdrawal.

Tax and Penalty Liability

If you have no option but to withdraw money from your retirement account, you can still roll over the amount to an IRA within 60 days of receiving the check without incurring taxes and penalties. This is known as an indirect rollover.

When you take the withdrawal, the plan administrator must withhold 20% for federal taxes. State tax withholding may also apply.

If you can’t make that rollover happen within the 60-day limit and you are younger than 59½, you must pay all the income taxes due plus a 10% early withdrawal fee.

If you can’t roll over the money within 60 days but want to avoid the mandatory tax withholding, you should have the amount processed to a traditional IRA as a direct rollover. This means the money will go directly from one plan to another without passing through your hands.

Then you can take the distribution from the IRA, which allows you to waive withholding. You will have to pay the taxes when you file, though. You may want to check with a tax professional to help you decide whether you should have taxes withheld to satisfy any requirements for paying estimated taxes.

A Last Resort

Withdrawing from your retirement plan should be a last resort, as you not only lose part of your nest egg but also damage its power to accrue earnings on a tax-deferred basis. The impact can be quite significant and could put you behind with your retirement program.

If you haven't left your job, you may be able to take a loan from your 401(k) instead of withdrawing the money. That can be a better option, but an option that has its own possible drawbacks.

Another Option

If you have left your job, you may be eligible for unemployment insurance in your state. See the U.S. Department of Labor website for details. This could provide sufficient income until you find another job and negate the need to tap into your 401(k) plan.

You may want to talk to a retirement or financial counselor for some additional financial guidance.

New Rules Due to COVID-19

The March 2020 passage of the Coronavirus Aid, Relief, and Economic Security Act (CARES Act), meant to combat the economic fallout from the COVID-19 pandemic, has temporarily changed some of the rules for early withdrawals and the tax liability.

The changes apply to what the law considers to be an eligible participant, namely, a person who has been diagnosed with COVID-19, has a spouse or dependent diagnosed with COVID-19, or has experienced a layoff, furlough, reduction in hours, or inability to work due to COVID-19 or lack of childcare because of COVID-19.

Eligible participants can take an early withdrawal (before reaching age 59-1/2) of up to $100,000 from 401(k)s, 403(b)s, 457s, and traditional IRAs without paying a 10% penalty.

There's a three-year time period for paying the taxes on the early withdrawal or to redeposit the money back into a retirement account (versus the standard repayment requirement of 60 days).

Additionally, there is no longer a 20% mandatory tax withholding at the time that the early withdrawal is made, as per the CARES Act.

Retirement plans are not required by law to accept this modification of early withdrawal rules, but most plans are expected to follow suit. The law covers withdrawals made between January 1, 2020, and January 31, 2020.

Advisor Insight

Steve Stanganelli, CFP®, CRPC®, AEP®, CCFS
Clear View Wealth Advisors, LLC, Amesbury, Mass.

You may access your 401(k) to fund your living expenses. However, [if you are no longer working for that employer] it must be a withdrawal. You will not be able to take out a loan, as you could have when you were an employee, but will instead have to pay what you take back by the due date of your federal income tax return that year.

How much this will cost you depends on your age. If you’re 59½ or older, you won’t have to deal with the 10% early withdrawal penalty. If you’re under 59½, you’ll have to pay the penalty, unless you use the funds for medical expenses that total more than 10% of your gross income. Then you’ll likely be eligible for an exemption. You can also avoid the penalty via the 72(t) rule: receiving “substantially equal periodic payments” over the next five years.

In all cases, your distributions will be counted as income in the year of withdrawal, and you’ll owe tax on them. It may help to have the 401(k) custodian withhold a percentage for taxes with each distribution.