You’ve been diligently contributing to your 401(k), receiving matching contributions from your employer, but now you may be wondering when you can withdraw from the account.
Because 401(k) plans are heavily regulated, there are restrictions on when you can start taking money out. We’ve compiled what you might need to know about 401(k) withdrawal and how to decide if and when it could be a good idea for you.
What are 401(k) plans?
At its most simple, a 401(k) plan is an employer-sponsored retirement savings account to which both you and your employer can contribute. Usually, you designate a certain amount from each paycheck to be transferred directly into your 401(k) account before it is taxed.
Many employers offer a matching contribution, which means that they will also contribute to your 401(k) retirement plan up to a certain amount (usually a percentage of your income).
This might give you an incentive to save for retirement because the only way to get the matching funds from your employer is to put in your own contribution. When you save with a 401(k) plan, your money is only taxed when you withdraw it from your account.
When can I withdraw from a 401(k)?
Because 401(k) accounts are intended to help you save for retirement, there are restrictions on when you can withdraw money. Generally, you can start to withdraw money from your 401(k) without penalties when you reach the age of 59½.
If you need to withdraw money from your 401(k) before you reach the age limit, you may face penalty fees for taking your money out early. However, there are limited circumstances in which you can reach into your 401(k) account before 59½.
Your specific 401(k) plan description should state clearly when your plan allows disbursements and if the plan allows 401(k) loans, hardship distributions, or cashing out your 401(k).
Some, but not all, 401(k) plans offer loans paid out from the money you have saved in your retirement account. If you fulfill the terms of the loan and pay the money back into your 401(k) account, the money won’t be subject to additional taxes.
The IRS caps the amount you can borrow from an eligible plan at either $50,000 or half of the amount you have saved in your 401(k), whichever is less. This means that you won’t be able to borrow all the money you’ve saved for retirement with a 401(k) loan.
One important thing to know about 401(k) loans is that you’ll likely have to pay an interest rate that’s one or two points higher than the prime rate — you won’t get a great interest rate just because you’re borrowing from your own retirement money.
Additionally, almost all 401(k) loans only have a five-year repayment plan, but if you use your 401(k) loan to buy a primary residence, you may be allowed more time to repay the loan.
401(k) hardship withdrawals
In addition to 401(k) loans, some plans allow for hardship withdrawals or distributions. If your 401(k) plan offers hardship distributions, it must clearly lay out the specific criteria required for borrowers to make a withdrawal.
Generally, a hardship distribution must be on account of an “immediate and heavy financial need” of the employee owning the 401(k) plan or that person’s spouse or dependents. The amount disbursed can only be what is necessary to meet the need.
The IRS has designated certain situations that qualify, including some medical expenses, buying a principal residence, tuition and educational expenses, preventing eviction or foreclosure on your primary residence, funeral costs and some expenses related to repairing damage to a principal place of residence.
Although the IRS has found these circumstances to constitute “immediate and heavy financial need,” specific 401(k) plans may not allow hardship distributions in all of those situations.
Plans may limit their hardship distributions to only medical expenses or to prevent eviction or foreclosure. And of course, if you have other ways to meet your financial need, you may not qualify for a hardship distribution.
Generally, hardship distributions can’t be more than the elective contributions you’ve made to your 401(k) account minus any previous distributions you may have received. The specific amounts that are eligible for hardship distributions will be governed by the terms of your plan.
If you take a hardship distribution, you may be barred from putting contributions back into your 401(k) account for six months.
Additionally, hardship distributions may be included in your gross income at tax time, which could affect your tax bill. And if you’re taking a hardship distribution because you’re not yet 59½, your distribution may be subject to an additional 10% tax penalty based on an early withdrawal.
Finally, unlike 401(k) loans, you don’t pay hardship withdrawals back. This means that your retirement funds are permanently reduced by the amount you withdraw.
Cashing out your 401(k)
If you no longer work at the company that sponsored your 401(k) plan, you may be able to “cash out” all or a portion of your 401(k), but this option can come with some serious consequences.
Cashing out your old 401(k) means you close down the account and keep the funds, essentially converting your retirement savings into immediately usable money. While cashing out your 401(k) — especially if you need the money now — might sound appealing, it can have some major downsides.
Perhaps the biggest downside is that cashing out your 401(k) before you reach 59½ is that the money will be subject to extra taxes. Normally, the money you put in a 401(k) is only taxed once, upon withdrawal during your retirement.
But if you pull the money out early, you not only will be subject to the ordinary income taxes that are triggered by the withdrawal, you will also be subject to a 10% penalty tax. That means that a significant portion of your 401(k) would go directly to the IRS.
Rolling over your 401(k)
Instead of cashing out your 401(k), you may choose to roll over your 401(k) into a different retirement account. Rolling over a 401(k) means you move the money from one retirement account to another, usually an IRA, which can help you avoid paying the penalty tax that comes with an early cash-out.
Rolling over your 401(k) could help you continue to save for retirement while avoiding fees — and reduce the number of retirement accounts you have open if you’ve left a 401(k) at a previous job.
Source: MSN Money / Featured image by pressfoto – freepik.com