If you find yourself in a bad financial situation, making an early withdrawal from your 401(k) may sound tempting. But early withdrawals from your 401(k) come with hefty fines and can put your retirement at risk. So, before you do this, you should be sure that it’s truly a financial necessity.
That being said, there are situations when it makes sense, and occasionally, you can find ways to get the fees waived. This article will review everything you need to know before making an early 401(k) withdrawal.
Can I make an early withdrawal from my 401(k)?
To determine if you are able to make an early 401(k) withdrawal, you should check with your human resources department, as not all employers offer this option. If you can, it may not be an easy process. It will largely depend on your age, the rules of your current plan, and your employer.
If you no longer work for the company that sponsored your first 401(k) plan, you’ll need to contact the plan administrator. They can walk you through how to withdraw the money early.
If you do still work for the same employer, there may be rules preventing you from withdrawing funds early. However, you can probably access a 401(k) loan instead, which we’ll discuss in more detail later in the article.
401(k) Early Withdrawal Penalties
If you’re under the age of 59 ½, the IRS could charge you a 10% fee. Furthermore, you may be required to pay income taxes on the money you cash out early since you paid these funds pre-tax. So, you may end up getting a lot less than you think you will.
If you’re withdrawing the funds due to financial difficulties, there may be a way for you to avoid the hefty fees. You may qualify for a hardship withdrawal.
What qualifies as a hardship withdrawal?
A hardship withdrawal allows you to take some of your funds out early without paying the standard 10% fee. However, every plan is different so you’ll need to prove that your situation meets the plan’s definition of hardship.
In short, there is no one-size-fits-all definition of financial hardship. You’ll need to talk to your plan administrator and see what they’re willing to accept. But here are some of the expenses that may be covered under a hardship distribution:
- Educational expenses: This can include tuition and room and board for yourself or any dependent children.
- Housing costs: This can include costs to avoid foreclosure on your home or unexpected repairs. But it usually won’t include mortgage payments.
- Medical expenses: Unexpected medical expenses for yourself or a family member may be included.
- Funeral arrangements: If a family member unexpectedly passes away, the cost of funeral arrangements may be included under the hardship distribution.
The Pros and Cons of Hardship Withdrawals
A hardship withdrawal may be the right answer for you, but there are several advantages and disadvantages you should consider first.
If you’re in a financial emergency, then having access to your retirement savings can be a huge advantage. This will save you from racking up credit card debt and digging yourself into a financial hole.
It can also give you a little peace of mind during a difficult season in life. If you’re dealing with a medical emergency or the death of a loved one, it may be worth it to you to ease any financial strain.
The only way to make your retirement savings grow is by saving money and leaving it alone. If you take out your money early, you could end up jeopardizing your retirement plans in the future.
And while the 10% fee is waived, the tax burden is not. So, you’ll want to speak to an accountant, run the numbers, and figure out if the financial hit is worth it.
Is a 401(k) loan a better option?
If a hardship withdrawal isn’t an option for you, you can consider a 401(k) loan instead. This allows you to avoid the 10% fee and the income taxes that come with it. However, many financial experts recommend that you only use this as a last resort option.
The biggest advantage of a 401(k) loan is that you are the lender since you’re borrowing against your retirement savings. So, once the crisis has passed, you don’t need to figure out how to repay a creditor. Plus, the interest rates tend to be much lower than taking out a personal loan or using a credit card.
You’ll also be able to skip the 10% fee and the income taxes that accompany an early withdrawal. The application process should be fairly simple, and you may be able to gain access to the funds pretty quickly.
Again, the biggest disadvantage is that you’re borrowing money against your retirement funds. You’re losing out on the opportunity to earn compounding interest and costing yourself money down the road.
And you could put yourself in a difficult situation if you leave or are let go from your current job. Some plans require that you repay the funds within 60 days, or it’ll be considered an early withdrawal. At that point, you’ll incur the taxes and the 10% fee.
What is a Substantially Equal Periodic Payments (SEPP)?
A Substantially Equal Periodic Payment (SEPP) is a distribution option for 401(k) and other qualified retirement plans. It allows you to receive payments from your account balance over a period of time, rather than taking a lump sum distribution.
The payments must be made at least once per year and must continue for at least five years or until you reach age 59 1/2, whichever is longer. The payments must also be in equal amounts and must be based on your life expectancy or the joint life expectancy of you and your designated beneficiary.
SEPPs can be a viable option for individuals who need to access the funds in their retirement account before reaching retirement age. They also allow you to avoid the early withdrawal penalty that is typically applied to distributions before age 59 1/2.
3 Alternatives to Early 401(k) Withdrawals
Before you decide to take out an early 401(k) withdrawal, here are three alternatives you can consider:
- Home equity loan: If you own a home, you may be able to borrow against the equity in your house. The interest rates on a home equity loan tend to be low so it may be a suitable option. However, your lender will require that you still have 20% equity in your home after the loan is taken out. And home equity loans come with closing costs so you’ll need to factor this into the total costs.
- Personal loan: If you don’t own a home or don’t want to put your home at risk, you might consider a personal loan. Personal loans come with higher interest rates, but they’re unsecured. This means you don’t have to put up any type of collateral first. And if you have excellent credit, you may be able to qualify for a personal loan with very favorable rates. But you may still be able to take out a personal loan with bad credit.
- 0% APR credit card: If you have excellent credit, you may also qualify for a 0% APR credit card. However, you should only do this is you’re sure you can repay the amount before the introductory offer expires. If you don’t, you’ll get stuck with a very high interest rate.
Making an early withdrawal from your 401(k) is not advised, but sometimes it can’t be avoided. You should take to your plan administrator and carefully weigh the pros and cons first. And you can consider alternatives like 401(k) loans, home equity loans, personal loans, or a 0% APR credit card.