In general, it is not advisable to withdraw money early from your 401K. Some of our clients ask us if they should take an early distribution from their 401K when they move back to their home countries. The answer is still usually no because there are penalties and tax consequences of doing so. You can leave your 401K right where it is and benefit from it in retirement, wherever you are living in the world. However, in some cases, especially financial hardship or early retirement, an early withdrawal (or distribution) from your 401K may serve as a viable strategy.
Options To Get Money Out of Your 401K
A “distributable event” is an event that allows distribution of a participant’s plan benefit and includes the following situations:
- The employee terminates or is terminated from their employment
- Your employer discontinues your plan and offers no new plan
- The employee suffers a significant financial hardship while still employed
- The employee reaches age 59½
When you leave your job you have four choices for your 401K:
- Leave the 401K where it is (if your employer allows it - most do)
- Roll the 401K into an IRA
- Roll the 401K into a future employer’s 401K
- Cash out (withdraw) the funds in the 401K (and pay the penalty)
What is an “early 401K withdrawal” or “early 401K distribution?”
An early withdrawal is a withdrawal that occurs before you are 59½ (or 55 in some circumstances)
There may be penalties for withdrawing funds from a 401K early.
- The penalty is 10% of the distribution
- Let’s say you have $100K in your 401K and you take an early distribution for $10K
- The penalty is 10% of $10K which is $1K
- If the 401K was a traditional (not Roth) 401K, then $10K will also be added to your income for the year and you will pay taxes on it, based on your taxable rate for ordinary income. If it was a Roth 401K, then $10K will not be added to your income
Early withdrawal penalties don’t always apply.
The 10% penalty doesn’t apply on an early distribution if:
- The participant has died and their beneficiary is collecting the balance
- The participant has a significant disability
- The person is separated from service during or after the year that the participant turned 55 (basically an early retirement) according to IRS Publication 575
- Is being made to a payee under a “qualified domestic relations order” sometimes called a QDRO
- The participant needs it for medical care
- The participant accidentally made an excess contribution or the employer accidentally made an excess contribution, and the contribution is withdrawn in the year it was made
- The participant needs it because of a natural disaster that the IRS has specifically indicated as qualified for an early penalty-free withdrawal
There are some situations in which it can be advisable to take an early 401K withdrawal
- It may be beneficial to cash out a portion of your 401K if you have a loan that has very high interest. For example, taking an early distribution on your 401K be wise to pay down credit card or personal loan with a very high interest rate. In this case, you may be financially better off cashing out the 401K and paying the penalty than continuing to pay that interest. However, it is important to do the math to determine whether it’s better to cash out a portion of the 401K or not
People may have different reasons for withdrawing funds early from a 401K
- Financial Hardship: People sometimes withdraw funds early due to financial hardship (also known as a “hardship withdrawal”). Example include: medical care, expenses related to the purchase of a home, tuition, and funeral expenses
- Discretionary Spending: People may withdraw funds from a 401K because they prefer to have the money now rather than save it for retirement. In general, we do not recommend this strategy
- Early Retirement: Some people retire earlier than the standard retirement age. In this case, it is understandable why they may want to access funds early since they are no longer working
What happens to my 401K if I’m an immigrant on H1B visa, and have to leave the United States?
- Nothing happens to it but you have some choices about what to do with it. As discussed above, if you terminate your employment and leave the United States, you may
- (1) Leave the 401K where it is
- (2) Roll the 401K into an IRA
- (3) Cash out (withdraw) the funds in the 401K
- We generally recommend that you pursue either (1) or (2) within Year 1 of leaving the US. Then you can leave the funds where they are until you reach retirement age
- If for some reason you must withdraw the funds because you need the money, cash out (withdraw) the funds in the 401K only up to the lowest tax bracket, such that you pay 0% US income taxes on your 401K withdrawal. In this case, you would still pay the 10% penalty on the withdrawal if you are taking the funds out before retirement age.
How do hardship withdrawals work?
- Hardship withdrawals only apply if you still work at the employer that administers the 401K. A hardship withdrawal can be made because of an “immediate and heavy financial need” and is limited to the “amount necessary to satisfy that financial need”
- Most plans stipulate that you can only withdraw your own contributions, not the employer contributions, but some plans allow both
- Your employer and plan administrator will provide specific criteria for hardship withdrawals if they do offer them. For example, one plan may allow hardship withdrawals for medical expenses but not for tuition. Debt repayment is not always considered an approved hardship.
- Requests for hardship withdrawals may be rejected if an employee is determined to have other resources available to meet the need including the assets of a spouse or children
- Some employers and plan administrators do not offer them.
- Hardship withdrawals are taxed as ordinary income and are subject to a 10% penalty if you are less than 59½ years old (or 55 in some circumstances)
- Hardship withdrawals are not a loan and you do not have to pay the amount back
- You may be prohibited from contributing to the 401K for several months after the hardship withdrawal
- Once you leave your employer, your reason for an early withdrawal no longer matters - you can withdraw as much as you want including the employer contributions, but you may have to pay ordinary income tax and a penalty
Is there a way to get the funds out of my 401K early without paying a penalty?
Option A: Rollover to an IRA And Withdraw (Allowed Under Certain Circumstances) - You can rollover your 401K to an IRA but that will not give you early, penalty-free access to your retirement funds. It simply transfers the funds from your employer’s retirement account to a personal retirement account that also has early withdrawal restrictions. If you rollover your 401K to an IRA, no taxes are withheld (unless you are transferring a pre-tax 401K to a post tax Roth IRA, also called a Roth Conversion). Rollover transactions are reported on Form 1099-R. You can rollover by having one institution pass the funds to another or you can actually withdraw the funds and move them yourself to a new institution within 60 days. If you choose this latter option, there will be mandatory withholding of 20%, so it is easier to do a direct institution to institution transfer. There may be an option to withdraw the funds early for specific reasons - IRAs are another type of retirement vehicle and have slightly different early withdrawal rules than 401Ks. If you rollover your 401K to an IRA, you may be able to withdraw money early penalty free for the following reasons: first time home purchase, tuition and educational expenses, disability, medical expenses, and health insurance
Need help with a rollover? Contact MYRA Wealth for a free consultation on your unique financial planning needs.
Option B: 401K Loan - Certain 401K administrators offer 401K loans. Generally, if your plan allows it, you can take a loan for up to 50% of the vested 401K account balance to a maximum of $50,000. You must repay the loan within 5 years unless you use the loan to buy your primary residence. There may be other requirements about how frequently you must make payments on the loan (for example you can’t pay it all back at the end of the 5 years, you must pay it over the 5 years). Your loan payments may be taken out of your paychecks. 401K loans are not usually considered taxable income but certain plans may treat them as taxable income. You will have to pay interest on the loan and the interest rate is usually the prime rate. In a 401K loan, you actually pay the interest to yourself. Some people have argued that this is a good investment but Michael Kitces explains in this blog post why that isn’t the case.
If you quit your job before paying back the entire loan, you will owe income tax and a 10% penalty on any amount that is not repaid. Thus, if you are planning to leave your job and may have taken out a 401K loan, you may want to consider paying off the loan before leaving or shortly after leaving to avoid the penalty.
Option C: Take substantially equal periodic payments using Rule 72t - this rule allows you to take early withdrawals from your retirement accounts without paying penalties as long as you take them in “substantially equal period payments” (SEPP) over your lifetime. What does that mean? You need to take consistent (the same) withdrawals each year for the rest of your life. Those amounts and the length of “the rest of your life” are based on IRS calculations. If you switch things up and start taking more or less or no distribution, you’ll incur the 10% penalty AND additional interest. Because this penalty is relatively severe, most financial advisors discourage this method. If your account balance ever hits $0, there are no penalties for having to halt your distributions. There are some calculators online that can help you determine what amount you’ll have to distribute to yourself every month if you want to use Rule 72t.
Taking a 401K Loan Might Not Be Such A Good Idea
A 401K is supposed to help you have money in retirement. When you temporarily take money out of the plan, it inhibits its ability to compound with interest or stock market growth. You may end up with less money in retirement than if you had left the money in your 401K. In addition, if you terminate your employment, you’ll owe a 10% penalty and income taxes on the balance unless you can pay the loan back right away. 401K loans may also have fees and the payment terms are often very inflexible. Finally, taking a 401K loan may be a sign of broader financial distress.
401K Loans Might Be A Better Option Than Other Personal Loans
401K loans generally have lower interest rates than loans you might get from your bank. In addition, there is no credit check. You can borrow for any reason whereas personal loans may only be available for certain uses.
Two situations when it might be an OK to take out a 401K loan include:
- An instance when you need access to cash for something like a medical emergency but cannot get a good interest rate on a loan due to your credit score
- You need to pay off high interest debt
But If You Leave Your Job Prematurely, You May Need To Pay Back the Whole Loan!
Under the new Tax Cuts and Jobs Act of 2017, you have until the filing deadline of your tax return to pay it off and avoid the consequences of an early distribution for any unpaid balance.
Before you withdraw the funds in your 401K early or take a loan, be sure to consider any penalties or taxes you will owe. And more importantly, don’t forget that your 401K is supposed to be for retirement.