Early Withdrawals from 401(k)s: Should You Do It?

If you’re thinking of signing up for a 401(k) through your company, great! Maintaining one is a huge step toward a financially independent retirement. In 2011, the last year for which the Census Bureau has data, Americans held a median of $30,000 in 401(k)s and thrift savings plans. Unfortunately, a growing number of employees are finding it difficult to keep contributions in their retirement accounts. Most use early withdrawals to meet serious financial needs outside of their current budgets, like tuition costs and medical expenses.

It’s impossible to predict all of the financial setbacks you’ll encounter and at some point, you may find that an early 401(k) withdrawal is absolutely necessary. If so, here’s a primer on how to take one a little more wisely.

What Are the Consequences of an Early Withdrawal?

Be prepared to pay a hefty penalty for most types of early withdrawals. If you’re below 59 ½, the government will tax your distribution like regular income and you’ll also owe a 10% fee on the distributions. Keep in mind that, in most cases, you can only withdraw from the amount you directly contributed to the plan, not from its earnings.

In some, limited, cases, it is possible to make early withdrawals without incurring the 10% fee, although you will still have to pay income taxes.

Under What Circumstances Should You (or Should You Not) Withdraw?

Because there are penalties on almost every early 401(k) withdrawal, it goes without saying that you should only make one for a very good reason. Large, unexpected medical bills qualify, and in some cases, will even cause your penalty to be waived. A vacation or a new TV, however, do not. Only consider an early withdrawal if you have an immediate financial need and absolutely no other way to meet the expense.

However, an early distribution is never ideal. Zachary Fineberg, investment advisor at Fineberg Wealth Management, says, “I would never recommend a client take an early withdrawal from a 401(k) unless they qualified for one of the exemptions to the penalty.” The 10% fee is waived for employees in one of the following situations:

You’re using the money toward tax-deductible medical expenses (that is, any medical expenses exceeding 10% of your adjusted gross income for adults under 65).
You’re permanently disabled.
You retire, or leave the employer associated with your 401(k), at 55 or older.
You must turn over part of your 401(k) to satisfy a court order (such as a divorce decree or separation agreement).

The conditions to obtain a hardship distribution are slightly different and may be found here. Fineberg warns against them, however, as they still incur the penalty.

Is an Early Withdrawal the Only Option?

If you’re only temporarily in a tight spot, some employers will allow you to take out a loan from your 401(k). Companies may or may not require specific reasons for the loan, but the basic rules are standard. Provided that you return the money – including interest, which goes back into your account – within five years, you won’t owe the penalty or income tax on the amount. If you default, however, you’ll owe both on the balance. The same conditions apply if you lose your job and can’t repay the rest within sixty days.

401(k) loans may seem relatively harmless, but Fineberg disagrees. Even if you pay interest, you’re still losing the potential growth of the money you borrowed. “If you’re like most Americans,” says Fineberg, “you’re most likely not saving enough for retirement as it is. Taking a loan will exacerbate this shortfall.”

How Should You Withdraw (and Pay it Back)?

Before making any withdrawals, consult the paperwork associated with your 401(k) to determine your plan’s rules. Different employers have different specifications for withdrawals and loans, so do your research. Then contact a financial advisor or tax professional.

Generally speaking, though, you’ll make withdrawals from your 401(k) through your employer. Human Resources can provide you with a form. Be sure that you clearly express the reason for the withdrawal if your penalty should be waived. If not, you’ll have to correct the mistake, and your full payment may be delayed.

If you’re paying back a loan, plans will often require substantial payments quarterly, but again, check with HR and a financial advisor for details.

Is a 401(k) Really for You?

Maybe not, if you don’t have an emergency fund already in place. It might be to your advantage to opt out of your employer’s 401(k) plan until you’ve accumulated six months of living expenses. Once you’ve established a healthy savings, you should absolutely opt in and contribute enough to receive matching funds. Then, when emergencies inevitably arise, you can leave your retirement account untouched.

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