Acan play a key role in your retirement income, so it’s important to resist the urge to retire early (at least before age 59.5). However, things happen – and there may be times in your life when you need a lump sum of money.
For example, you might have a medical emergency, need a down payment for a house, or want to pay your child’s school fees. If you find yourself in this situation, make sure you know the consequences of early withdrawal.
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If you’re still considering withdrawing from your 401(k) early, here’s what you need to know about the tax penalty.
What is a 401(k) plan?
Traditional 401(k) plans are employer-sponsored retirement accounts. They allow you to contribute to pre-tax earnings through automatic payroll deductions. Employers can also contribute to your account by matching your contributions or making non-matching donations.
Your 401(k) account balance grows over time, not just through contributions, but through interest returns. However, the Internal Revenue Service (IRS) limits how much you can contribute every year and when you can take distributions without penalty.
What is a 401(k) early withdrawal?
An early withdrawal from a 401(k) occurs when you receive distributions from your account before age 59½.
The accounts are designed to provide you with an additional source of income during retirement, hence the age requirement for distributions. If you decide to withdraw your 401(k) early, the IRS will charge you a penalty.
401(k) early withdrawal penalty
The penalty for making a non-exempt early withdrawal from your 401(k) is a 10% tax on the amount of the distribution. You must report 401(k) distributions on your tax return for the tax year in which you made the withdrawal. The amount due will be taken into account in your overall tax balance due or refunded to you.
For example, if you are a 35 year old single filer and earned $60,000 in 2022, your tax rate would be 22%. If you take a 401(k) distribution of $20,000, you will add the $20,000 to your income for the year, which could affect your tax rate.
In this case, you would still fall into the 22% tax rate class. As a result, you would pay $4,400 in income tax on the distribution and an additional $2,000 for 10% tax on the early distribution. In total, the early distribution would cost you $6,400, leaving a net amount of $13,600.
It’s generally best to leave your 401(k) funds in your account until retirement. This maximizes the interest earning potential of the account and avoids significant tax penalties. However, in some situations, cashing out some or all of your 401(k) may be the best option available. When this is the case, make sure you understand the costs you should expect and the impact of the distribution on your retirement income.
How to avoid an early withdrawal penalty
You can avoid the 401(k) early withdrawal penalty by waiting to be 59½ to receive distributions from your plan. The IRS also lists various situations that could exempt you from the 10% tax, such as taking an early distribution due to a qualifying disability or reducing excess contributions. Make sure you review the list of exemptions to see if your situation qualifies.
Another way to avoid the 10% early withdrawal tax is to take out a loan from your 401(k) account. Your loan amount will not be taxed as a distribution as long as:
- You borrow 50% or less of your acquired balance – up to $50,000.
- The loan is repaid in five years (unless you use it to buy your principal residence).
- Your payments are substantially level.
- Payments are made at least quarterly over the life of the loan.
Although 401(k) loans can be a good alternative, not all plan providers offer them, so you’ll need to check if this is an option for you.
Alternatives to 401(k) Withdrawal
How can you access money without withdrawing or borrowing from your 401(k)? If you own a home with equity, you may want to consider a cash out, home equity loan or home equity line of credit (HELOC). These three options usually come with competitive interest rates because the financing is secured by your home.
Permanent life insurance policies with cash value elements are another option. In this case, your death benefit serves as collateral for the loan. Once the loan balance is paid off, your death benefit is restored in full. You don’t have either? You can also view personal loans from a wide variety of online lenders. The better your credit and your income, the more competitive offers you can access.