Best ways to use your 401(k) without a penalty

The 401(k) plan is an employer-sponsored retirement plan that millions of workers depend on for funding their retirement years. The best way to use your 401(k) is to take normal distributions after you reach retirement age. By doing so, you will avoid paying any unnecessary taxes and be able to use your savings for anything you want. However, if you choose to make withdrawals from your 401(k) fund before you retire, there are also a few ways to access your savings without incurring a penalty.

Take Normal 401(k) Distributions

Under normal 401(k) distribution regulations, funds can only be withdrawn from your account once you reach age 59.5, become permanently disabled or are otherwise unable to work. Depending on the specific terms of your plan, you may elect to take a series of regular distributions, such as monthly or annual payments, or receive a lump-sum amount upfront.

If you have a standard 401(k), you are required to pay income tax on any distributions that are taken. However, if you have a Roth IRA account, your contributions were made with after-tax dollars, so withdrawals from that account can be taken tax-free.

Make a Hardship Withdrawal

In general, any distribution you elect to take from your 401(k) before reaching age 59.5 is subject to an additional 10% tax. Depending on your plan, however, you may be eligible to take early distributions from your 401(k) without incurring this penalty if you meet certain criteria.

This type of penalty-free withdrawal is called a hardship distribution and can only be taken if the plan participant is deemed to have an immediate and heavy financial burden that could not otherwise be afforded. The practical necessity of the need is considered, as are the participants' other assets, such as savings or investment account balances and insurance policies, and the availability of alternative financing.

Items such as new vehicles or cosmetic surgery, for example, are not considered necessary. However, expenses such as tuition and related fees, funeral costs and necessary medical care are all approved financial hardships, whether the expense is foreseeable or voluntary.

Hardship distributions are only allowed up to the amount of the financial hardship. Any withdrawal exceeding this amount is considered an early distribution and is subject to the 10% tax. In addition, hardship distributions must include only employee-contributed funds and cannot include employer contributions or interest earned on the account. Any hardship distribution must be approved by a plan administrator.

Request a Loan From Your 401(k)

If you do not meet the criteria for taking a hardship distribution, it may still be possible to take a loan from your 401(k) before retirement. The specific terms of these loans vary between plans. However, the IRS provides some basic guidelines for choosing this option without having to pay the additional 10% tax on early distributions.

If allowable under your plan, loans taken from your traditional or Roth 401(k) cannot exceed the lesser of 50% of your vested account balance or $50,000. Although you may take multiple loans at different times, the $50,000 limit applies to the combined total of all outstanding loan balances.

A loan taken from your 401(k) must be repaid within five years, unless it is used to finance the purchase of your primary residence. Payments must be made in regular and substantially equal installments. For those who are absent from work serving in the armed forces, the term of the loan is extended by the length of their military service without penalty.

Like other types of financing, loans from a 401(k) require the payment of interest. However, any interest paid is deposited back into the 401(k) and treated as investment income. This means instead of paying a bank for the privilege of borrowing money, you will pay yourself, increasing your total balance.

The Bottom Line

The simplest way to use your 401(k) without incurring a tax penalty is to always use it as intended – for retirement income. However, by meeting certain conditions, you may be able to fund important but expensive events, such as going to college or getting necessary medical treatment with distributions and loans from your retirement account.