Understanding 401(k) Withdrawal Rules

The 401(k) retirement plan is a cornerstone of financial security for many Americans, providing a tax-advantaged way to save for retirement. While contributing to a 401(k) is relatively straightforward, withdrawing funds is often a bit more complex. Here’s everything you need to know to make the most of your 401(k).

401(k) withdrawal basics

A traditional 401(k) uses both the carrot and the stick to help you save for retirement. The carrot? Tax advantages and a potential employee match, making a 401(k) an excellent way to make the most of your retirement savings dollars. The stick, however, is penalties associated with early withdrawals.

For the purposes of a 401(k) account, “early” is defined as anything prior to the age of 59½. If you’re 59½ or older, however, you can take qualified distributions (which are penalty-free withdrawals). Anyone who requires access to 401(k) funds prior to this age may incur a 10% early withdrawal penalty in addition to regular income tax on the amount withdrawn. Take note this does not apply to Roth 401(k)s, for which you can generally withdraw your contributions (but not earnings) tax-free at any age.

Early withdrawal penalties

Let’s walk through a quick scenario to understand just how much early withdrawals can cost you. If you withdraw $10,000 from your 401(k) account before age 59½, the ten percent penalty would cost $1,000—but you’re also paying income tax on that withdrawal, meaning your total take-home amount could be closer to $7,000 based on your tax bracket. This isn’t the only issue with taking an early withdrawal, however. You also miss out on potential earnings that money could have made if it remained in your account. This is especially true if you’re younger, with the power of compounding meaning this can add up to a sizable amount of money. Just how much, exactly?

If you have $40,000 in your 401(k) and were to earn an 8% return each year (we’ll assume you’re not making additional contributions, for simplicity’s sake), you would have $186,438 after 20 years; but if you withdrew $10,000 and therefore only had $30,000, you would have $139,829 after 20 years (assuming everything else remains the same). That’s a difference of $46,609—all due to a $10,000 withdrawal!

Hence, early withdrawals cost you. If this is your only option, however, some exceptions to early withdrawal penalties do exist. Keep in mind that penalty-free doesn’t mean tax-free, so 401(k) withdrawals made with pre-tax contributions are taxed at your ordinary income rate. While not a complete list, some of the most common exceptions to the early withdrawal penalty include:

• Enduring financial hardship, such as medical expenses or preventing eviction

• Leaving your job at the age of 56+

• Being or becoming disabled

• Dividing a 401(k) in a divorce

• Giving birth to or adopting a child that same year (up to $5,00 per account)

• Being a first-time home buyer (up to $10,000)

Furthermore, military service members and reservists may have additional exceptions: ensuring access to retirement savings during periods of active duty or other qualified service.

401(k) loan rules

Another way to access 401(k) funds prior to the age of 59½ is via a 401(k) loan, which some plans allow. If you choose to go this route, the interest you pay on the loan goes to you and the loan is not taxable/won’t impact your credit score.

You can typically borrow up to 50% of your vested account balance or $50,000—whichever is less—and must repay the loan within five years (with an exception made for loans used to purchase a primary residence). Keep in mind that if you fail to repay the loan according to set terms, this may be considered a distribution and thus subject to taxes and penalties.

Withdrawals between age 59½ and age 72

This is the withdrawal sweet spot. If you want to withdraw funds from your 401(k) during these specific years, you can do so penalty-free but are also not required to do so yet. The decision to withdraw funds during this window will ultimately depend on a variety of factors including your current employment status, other retirement income sources, and (of course) tax implications.

Traditional 401(k) withdrawals are generally subject to regular income tax, with the tax rate based on your overall income and the amount withdrawn. For Roth 401(k)s, qualified withdrawals are tax-free—providing tax diversification in retirement.

Required minimum distributions (RMDs)

After you turn 73 (75 beginning 2033), you must begin taking required minimum distributions (RMDs) from your 401(k). This amount is calculated based on your life expectancy and account balance (the IRS provides tables for RMD calculations).

Note that you must take your RMD by December 31st each year, but a few options are available with respect to taking your very first RMD. For example, if you turn 73 in 2023, you can do so by either December 31, 2023 or April 1, 2024. Just know that no matter which option you choose, you’ll need to take your second RMD by December 31, 2024.

Failing to take timely RMDs can result in a substantial 25% penalty on the amount you should have withdrawn.

Planning your withdrawals

Effective 401(k) withdrawal planning is essential to ensure your retirement savings last throughout your retirement years.

If you plan to retire before age 59½, you'll need to carefully consider your withdrawal strategy to minimize penalties. Techniques such as Roth IRA conversions can help in this regard. Some 401(k) plans allow for "in-service" withdrawals, permitting you to withdraw money from your account while still employed. These withdrawals may have certain restrictions and tax implications, so it's essential to understand your plan's specific rules.

Also keep in mind that 401(k) rules and regulations aren’t static and can change over time, meaning you’ll want to check in on your retirement plan with your financial advisor and make any updates as needed.

In sum: 401(k) withdrawal rules

Understanding 401(k) withdrawal rules is crucial to maximize the benefits of your retirement savings while minimizing penalties and taxes. Whether you're planning for early retirement or navigating the complexities of RMDs, careful planning and a sound knowledge of the rules can help you make the most of your 401(k) and enjoy a financially secure retirement.

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Vision Retirement is an independent registered advisor (RIA) firm headquartered in Ridgewood, New Jersey. Launched in 2006 to better help people prepare for retirement and feel more confident in their decision-making, our firm’s mission is to provide clients with clarity and guidance so they can enjoy a comfortable and stress-free retirement. To schedule a no-obligation consultation with one of our financial advisors, please click here.

Disclosures:
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.