We all know the best way to use your 401(k) plan: Wait until you retire, then start taking orderly distributions from your account to live on. That's what this employer-sponsored savings program was established for, after all—and besides, if you don't, the IRS socks you with a 10% early withdrawal penalty, plus taxes, on the funds you take out.

But life happens. If you really need to tap into that retirement account prematurely, there are several ways to do so without incurring a penalty.

Key Takeaways

  • If you are in dire need of funds, you may be able to tap into your 401(k) funds without penalty, even if you're under 59½.
  • Certain immediate and heavy expenses, involving healthcare, a primary residence, and education costs, qualify for a hardship withdrawal, which doesn't incur a penalty (though it does incur income taxes).
  • You may also be eligible to take a loan from your 401(k), which incurs neither penalty nor taxes, though you are required to pay the money back.

Taking Normal 401(k) Distributions

But first, a quick review of the rules. The IRS dictates you can withdraw funds from your 401(k) account without penalty only after you reach age 59½, become permanently disabled, or are otherwise unable to work. Depending on the terms of your employer's 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 traditional 401(k), you will have to pay income tax on any distributions you take, at your current ordinary tax rate (because you got a tax break on the contributions at the time you made them). However, if you have a Roth 401(k) account, you've already paid tax on the money you put into it, so your withdrawals will be tax-free. That also includes any earnings on your Roth account.

After you reach age 72, you must generally take required minimum distributions (RMDs) from your 401(k) each year, using an IRS formula based on your age at the time. If you are still actively employed at the same workplace, some plans do allow you to postpone RMDs until the year you actually retire.

In general, any distribution you take from your 401(k) before you reach age 59½ is subject to an additional 10% tax penalty on top of the income tax you'll owe .

Making a Hardship Withdrawal

Depending on the terms of your plan, however, you may be eligible to take early distributions from your 401(k) without incurring a penalty, as long as you meet certain criteria. This type of penalty-free withdrawal is called a hardship distribution, and it requires that you have an immediate and heavy financial burden that you otherwise couldn't afford to pay.

The practical necessity of the expense is taken into account, as are your other assets, such as savings or investment account balances and cash-value insurance policies, as well as the possible availability of other financing sources.

What qualifies as "hardship?" Certainly not discretionary expenses like buying a new boat or getting a nose job. Instead, think along the lines of the following:

  • Essential medical expenses for treatment and care
  • Home-buying expenses for a principal residence
  • Up to 12 months worth of educational tuition and fees
  • Expenses to prevent being foreclosed on or evicted
  • Burial or funeral expenses
  • Certain expenses to repair casualty losses to a principal residence (such as losses from fires, earthquakes, or floods)

The home-buying expenses part is a bit of a gray area. But generally, it qualifies if the money is for a down payment (especially if putting up the cash will help you get a mortgage) or for closing costs.

Hardship Loan Terms

Hardship distributions are only allowed up to the amount you need to relieve the financial hardship. Withdrawals exceeding that amount are considered early distributions and are subject to the 10% penalty tax. Any hardship distribution you wish to take must be approved by your plan administrator.

You will still owe income tax on your distribution, although, in the case of a Roth 401(k), only a portion of the distribution may be taxable.

Requesting a Loan From Your 401(k)

If you do not meet the criteria for a hardship distribution, you may still be able to borrow from your 401(k) before retirement, if your employer allows it. The specific terms of these loans vary among plans. However, the IRS provides some basic guidelines for loans that won't trigger the additional 10% tax on early distributions.

Whether you can take a hardship withdrawal or a loan from your 401(k) is not actually up to the IRS, but to your employer—the plan sponsor—and the plan administrator; the plan provisions they've established must allow these actions and set terms for them.

For example, a loan 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.

401(k) Loan Terms

Any loan you take from your 401(k) has to be repaid within five years unless it is used to finance the purchase of your primary residence. You must also make payments in regular and substantially equal installments. For employees who are absent from work because they're 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, the interest you pay is deposited back into the 401(k) and treated as investment income. This means that instead of paying a bank for the privilege of borrowing money, you will pay yourself, eventually increasing your total balance.

One big caveat to bear in mind: If you lose or resign from your job, you will have to pay back the loan by the due date of your federal income tax return, including extensions.

The Bottom Line

The simplest and best way to tap your 401(k), without incurring a tax penalty, is to use it for the purpose it was intended for—providing retirement income. However, if you need money for a major expense, such as important medical treatment, a college education, or buying a home, you may be eligible for a hardship distribution or 401(k) loan.