How to take funds out of a 401(k) early without a penalty
The IRS sets rules on the age when Americans can and must begin drawing on their retirement funds without incurring a penalty. But there are exceptions.
Uncle Sam wants Americans to not just rely on Social Security benefits when they stop working but to build up a private retirement fund as well. In order to encourage this, the United States federal government provides various tax incentives savers can take advantage of when putting money away for retirement.
One such is a 401(k) plan through their employer which depending on the type could come with upfront tax benefits or tax-free distributions when you retire.
However, if you need to withdraw money from your 401(k) plan before you turn 59½ you could incur a hefty penalty. Although, there are some cases where you can withdraw funds from your 401(k)-retirement nest egg without being punished.
You may also be interested in: What happens to my 401(k) if I change jobs?
The basics of 401(k) plans
Named after a section of the US Internal Revenue Code, a 401(k) is a retirement savings and investing plan offered by many American employers. Contributions are automatically taken out of a worker’s paycheck and invested in funds selected by the employee from a list given to them by the plan administrator.
With traditional 401(k) plans, the funds are withdrawn from the pre-tax amount of a paycheck and the employee gets a tax break upfront. However, they will be liable to pay income taxes on them when they withdraw down the road. A Roth 401(k) plan works the other way around, you pay in with after-tax money and then in retirement you don’t pay tax on qualified withdraws.
An added benefit is that employers often offer to match your contributions if you put at least a certain amount into your 401(k) plan. Every year the IRS adjusts the maximum amount that employees can contribute to their retirement funds. For those 50 and over who need to put extra money into their nest egg in the run-up to quitting the nine-to-five, they are allowed additional amounts in the form of catch-up contributions.
The age when you can begin to make withdraws from 401(k) plans
When you can begin taking “qualified” distributions from your 401(k) plan depends on your age at retirement and the rules set by your company. If you make “unqualified” withdraws you will have to pay Uncle Sam a cut.
You can make qualified withdraws after you retire and have turned 59½ from a traditional 401(k) plan. It’s the same case with Roth 401(k) plans but you must also have held the account for a minimum of five years from the date you began contributing.
How to take funds out of a 401(k) early without a penalty: The 401(k) Rule of 55
Between the age of 55 and 59½ you can pull money out of a 401(k) plan in the event that you get laid off, fired or quit your job without being penalized. There are also instances where you can borrow against you 401(k) to purchase a house.
Otherwise if you dip into your 401(k) savings before you are 59½ you’ll have to pay 10 percent penalty and taxes on any money you withdraw. How unqualified distributions from a traditional and a Roth plan are taxed differ when withdrawing funds.
The full amount that you pull out of a traditional 401(k) plan will be subject to a 10 percent penalty in addition to income taxes. Whereas, because you already paid taxes on the money that you put into a Roth 401(k) plan you’ll pay a pro-rata amount of your contributions, which are non-taxable, and earnings, which are taxable.
Required Minimum Distribution
When you retire, you can no longer put any more money in your 401(k) plan but depending on your age, you are not required to start taking distributions right away. You generally have to start taking required minimum distributions (RMDs) by April 1 the year after you turn 72. But for the age has increased to 73 for those who turned 72 after 31 December 2022.
For a complete run down on the RMD rules, the IRS provides details on different retirement plans and tools.
The amount that you need to withdraw on a regular periodic basis is calculated using your account balance and life expectancy. You cannot pull out less than your required minimum distribution but you are allowed to take out more than that amount in any given year.