It happens that expenses pile up and circumstances you did not foresee suddenly occur. If your emergency fund is drained, you could be looking at tax-advantaged employer retirement accounts. For this reason, this piece explains how to withdraw from 401(k) without penalty.
If you withdraw from your 401(k) before the age of 59½, you have to pay a 10% penalty on it. However, you can bypass the penalty through some early distributions, including higher education, buying a first home, and hardships. Unfortunately, the IRS does not count, for instance, flat broke as a hardship. But you could still use your retirement plan without penalty before you clock 59½.
What is a 401(k) Penalty?
If you withdraw money from your 401(k) before your retirement age before you clock 59½, you have to pay 10% in income tax.
Note that the 10 percent you are charged before your retirement age is the penalty. Also, “penalty-free” withdrawal does not mean it is tax-free.
When you withdraw from 401(k) with pre-tax contributions, you are taxed as ordinary income rates. Nondeductible contributions, such as those after-tax, to 401(k) are not subject to similar taxes as those of deductible contributions. Nonetheless, workers still have to pay taxes on their earnings they withdraw from the accounts.
You can take out contributions to your 401(k) at any time. If you wait till you turn 59½, you can withdraw your earnings penalty-free and tax-free if you have had an account in the past 5 years. However, the employer’s plan must permit it.
In some cases, employer plans may not offer penalty-free withdrawals and do not have to necessarily provide for hardship withdrawals. A lot of them do but may permit hardship withdrawals in certain cases. For example, for funeral and medical expenses, but will not for education purposes and housing.
How to Withdraw from 401(k) Without Penalty
In this section, you will discover how to take a penalty-free withdrawal from your 401(k) account. Below are the ways to withdraw from 401(k) without penalty:
If you have a permanent disability, you can withdraw from 401(k) without penalty i.e., without paying a 10 percent penalty. You can collect disability payments from social security or your insurance company to easily prove disability to the IRS.
You withdraw money from your 401(k) to buy a home by withdrawing or taking a loan from the account. A 401(k) is limited in amount and is repaid with interest but you will not incur a tax penalty or income tax.
Withdrawing money from your 401(k) for a down payment on a home can be tricky. If your 401(k) has both hardship and loan withdrawal provisions, you must use the loan provision first before you go for hardship.
Owing Taxes to the IRS
You can withdraw from 401(k) without penalty if the federal government comes after you for unpaid taxes. This means that if you have a levy placed against your account, you are allowed to make a withdrawal without penalty.
Health Insurance Premiums
If your 401(k) money is needed to pay health insurance premiums, you can withdraw it without penalty if you are unemployed. However, it must be with proof that you are unemployed for 12 weeks. In the case of an audit, you can make your trail clean by having a separate bank account for receiving payment from the 401(k), and then use it for your health insurance premiums only. You can also send the money to your insurance carrier directly.
Deductible Unreimbursed Medical Expenses
You can withdraw money from your qualified retirement plan to cover your unreimbursed deductible medical expenses if it exceeds 10% of adjusted gross income.
However, you must withdraw the money the same year you incur the medical bills. You can avoid the 10 percent tax penalty without itemizing deductions.
Death of Account Holder
If the account owner dies, the beneficiaries can withdraw money from 401(k) without the penalty of 10 percent. If the spouse inheriting a 401(k) account chooses to treat it as their own, the IRS will impose restrictions. In this case, withdrawing from 401(k) is subject to a penalty if the spouse takes a distribution before turning 59½.
You can take money from your 401(k) retirement plan without penalty, thanks to Section 72(t) of the tax code. However, there are restrictions. For example, you have to take substantially equal payments made periodically over time.
The payment must be made in 5 years. You can take a distribution yearly for 5 years or when you turn 59½. For instance, a retiree may want to remove money from 401(k) before Social Security kicks. You can take the payment but you will pay taxes. However, no penalty even if you are 52 or 53 years old.
If you are enrolled in 401(k) and do not want to be enrolled, permissive distributions could be allowed without penalty.
How to Avoid Early Withdrawals from Your 401(k)
Consider the 401(k) as your last resort for withdrawing money. Below are the ways you can avoid withdrawing from your 401(k) early:
Use Promotional Credit Card Offers
You should consider using an introductory credit card offer that includes 0% interest for the given period. Although this can help to finance your spending needs, do not allow the balance carry over when there is a higher interest rate.
Create an Emergency Fund
It is advisable to save about six months’ worth of your expense. It should even be the basis of your financial plan to stop you from using 401(k) early.
You can save your money in a high-yield savings account for more interest than in a conventional checking account. With an emergency fund, you should be able to manage some of your challenges.
Seek Help from People
You can rely on friends, family and your immediate community for financial support if you are facing tough times. This allows you to make ends meet without tapping from your 401(k) early. In most cases, friends and family forgive your debt faster than financial institutions when you obtain a loan. This does not mean you should take out loans from friends and family to resolve your problems at their detriment.
What qualifies as a hardship withdrawal for 401k?
A 401(k) withdrawal qualifies as a hardship withdrawal if you withdraw because of an immediate and heavy financial need, and you have no money or way to meet the need. Your withdrawal must not be more than your hardship amount.
Can I cash out my 401k while still employed?
You can cash out 401(k) while you are still employed, however, you cannot withdraw your 401(k) while still employed in the company that sponsors it.
In many circumstances, you will incur a 10 percent penalty when you withdraw early from your 401(k). You can also incur income tax which adds up to reduce your final payment. This article has mentioned the instances when taxes are waived but you may still have to pay income tax. If possible, avoid withdrawing from your 401(k) at all. You can build a strong emergency fund for difficult times.