A 401k – or 401(k) – is a retirement savings account/investment tool that is widely available and pretty powerful under the right circumstances. You can use them to basically take pre-tax dollars, have them matched by your company (hopefully), and then invested in stocks, money market accounts, mutual funds, and bonds to grow over time.
The end result, ideally, is that your pre-tax dollars have accumulated month after month, year after year, until – with the power of compound interest – you have a nice nest egg ready for your retirement.
For this reason, over 50 million Americans have a 401k, with assets over $2.8 trillion. Those numbers have dropped somewhat as individual retirement accounts (IRAs) have become more popular, but they are still quite robust. Of course, even though there are advantages to using a 401k, there are disadvantages: you can’t touch your money until the age of 59 ½ – otherwise, you’ll pay a steep penalty.
That is bad news for many people who need access to their money well before they reach that magical age. In this article, I’ll talk about how you can get money out of your 401k without paying penalties.
What You’re Up Against: Penalties
First, we’ll take a look at the 401k withdrawal requirements and limitations and discuss the penalties for jumping the gun and raiding the account before it’s time to do so.
I’ll start by saying that you can withdraw money from your 401k at any time. It’s your money, after all; you have the right to pull your funds or even take out loans against them (more on that later). When you do, though, you not only have to pay taxes on your withdrawals; you also have to pay penalties.
These penalties can be pretty steep. If you withdraw money early, it is subjected to what is called an excise tax, which in this case is equal to 10% of how much you are withdrawing. In other words, expect to lose 10% of the taxable amount instantly, plus any income taxes you have to pay on the withdrawal.
No one wants to lose a 10% chunk of their hard-earned investment, which is why most people leave their 401k plans untouched until they come of age. But, sometimes you need access to the money for emergency funds.
Fortunately, there are ways to access it without penalty.
Avoiding Paying Penalties on Your 401k
There are certain exemptions that could keep you from paying the 10% early-withdrawal penalty. These are called hardship exemptions and give you a way out – provided you meet the criteria. Hardship exemptions include:
- Death of the plan participant (which doesn’t help you but could help your family)
- You become permanently disabled
- You had to pay out of pocket for medical expenses that exceed 7.5% of your adjusted gross income
- You were forced to disburse funds by a court order following a divorce or separation
- You are over the age of 55 and retired or left your job
- You are leaving your place of employment and scheduled a payment schedule that gives you money in equal payments over the course of your life expectancy
Those are the hardship exemptions – and the IRS is very strict when it comes to giving them out. Basically, this isn’t for buying a new house (something that’s allowed under an IRA), or a new boat, or putting someone through college, or fixing up your home. This is an emergency measure and you have to demonstrate real need – not only to the federal government but also to your employer, who may have additional withdrawal guidelines you have to follow.
If you are met with an immediate and severe financial burden, without any other way to pay for these expenses, you may qualify; if not, you’ll have to pay a penalty.
The other option to get money from your 401k is to take out a loan against the balance. You have to pay back this amount, naturally, but the good news is that you can avoid a penalty. You do have to pay interest and fees, but you’re really paying interest to yourself. Taxes, though, may not be avoidable.
Repayment for these loans occurs over a five-year time period. So, if you can pay them back, taking out a loan to access your cash in the event of an emergency may not be a bad idea. Keep in mind interest and fees, though. Plus, if you happen to quit your job or be fired or laid off while a loan is active, the full amount is due within 60 days.
Taking out a loan or meeting one of the criteria for hardship withdrawals are really the only two ways you can get money from your 401k without having to pay the 10% penalty.