The 401(k) is an employer-sponsored retirement plan that millions of American workers depend on to help fund their retirement years. The best way to use your 401(k) is simply to take normal distributions after you reach retirement age. By doing so, you will avoid tax penalties on early withdrawals and keep all that money working for you until you retire. However, if you need to make withdrawals from your 401(k) before you retire, there are several ways to do so without incurring a penalty, as we'll explain.

Key Takeaways

  • The very best way to use your 401(k) is to leave the money untouched until you retire.
  • If you need money because of a financial hardship, you may be able to take a 401(k) distribution without penalty.
  • You may also be eligible for a penalty-free loan from your 401(k) if your employer's plan allows it.

Taking Normal 401(k) Distributions

Under the Internal Revenue Service (IRS) rules, you can withdraw funds from your 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. 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 70½, 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. Some plans, however, allow you to postpone RMDs until the year you actually retire.

Making a Hardship Withdrawal

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.

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. 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.

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.

Expenses like a new boat or elective cosmetic surgery, for example, are generally not considered necessary. However, essential medical care, funeral costs, and college tuition and related fees all can qualify.

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.

Requesting a Loan From Your 401(k)

If you do not meet the criteria for a hardship distribution, you may still be able to take a loan 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.

If you take a loan from your 401(k) and then lose your job, you might have to pay it back immediately.

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.

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 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, 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.