Avoid 401(K) Early Withdrawal Penalty

Avoid 401(K) Early Withdrawal Penalty

When a financial crisis arises, you may be tempted to take money out of 401(k) to make ends meet. But experts urge you not to make that mistake – and for good reasons. Withdrawing funds from your 401(k) could have major financial repercussions, including the taxes on 401(k) withdrawal. Besides, you’d deprive yourself of a comfortable retirement.

Your 401(k) should be a source of retirement savings, not a support system for financial emergencies. You would want to know what else you can do to survive the financial turmoil. Also, what are the drawbacks of 401(K) early withdrawal? You will find answers to your questions in this article.

What is the Penalty for a 401(K) Early Withdrawal?

The IRS has imposed a 10% penalty on early withdrawals of 401(K). Moreover, the money you take out will be included in your taxable income and reported on your tax return. Depending on your tax bracket, you may be paying taxes on your 401(k) at a rate of anywhere from 10% to 37%.

IRS has set an age restriction, so you must be at least 59½ years old to withdraw without incurring a 10% penalty. Keep in mind that withdrawing money from your 401(k) plan before the minimum 401(K) withdrawal age means you’re depleting your retirement savings, in addition to paying the taxes and penalty.

If you take the money out now, you won’t have that financial security when you need it later. So think twice before you do that!

How to Take Money Out of 401(K) Without Paying 401(k) Withdrawal Penalty?

Taking money out of your retirement account can come with taxes and a 10% penalty. However, there are certain extraordinary situations in which you can avoid that penalty. They are:

  • Disability
  • Medical cost
  • First home purchase
  • Child support
  • Spousal support
  • Death
  • Active military duty

Even if you don’t meet these requirements, you may still be able to make a penalty-free 401(K) withdrawal if you can use the rule of 55. According to the rule of 55, IRS permits you to withdraw from your 401(k) plan without penalty if you are between the ages of 55 and 59½ and lose your employment.

Another way of dogging the 401(k) withdrawal penalty is the Substantially Equal Periodic Payment (SEPP). With Rule 72(t) of the Internal Revenue Code, you are allowed to take out early withdrawals in the form of regular SEPP payments over five years. Or else, you can keep getting these payments till you reach the age of 59½. Whatever happens first would be considered.

Are There Any Alternatives to 401(K) Withdrawal?

If you’re looking for alternatives to a 401(k) early withdrawal, fortunately, there are several options to consider. Here are 4 options that could be right for you.

  1. 401(k) Loans

One alternative to an early withdrawal from your 401(k) is to take out a loan against it. With a 401(k) loan, you can borrow up to 50% of your vested balance, up to a maximum of $50,000, without paying any penalties or taxes. But it’s worth remembering that you need to repay the loan within 5 years or risk paying a 401(k) withdrawal penalty of 10%.

  1. 401(k) Rollover

If you need to access your retirement savings without taking a loan, you may want to consider a 401(k) rollover. This allows you to move your retirement account funds to another retirement account without incurring any taxes or penalties. This is an excellent option if you plan to switch jobs or diversify your retirement savings.

  1. Convert to a Roth IRA

By converting your 401(k) funds to a Roth IRA, you can avoid paying taxes or penalties on any withdrawals you make. However, you will have to pay taxes on the money you convert.

It may be wise to consider withdrawing funds from your Roth IRA first if you have made enough contributions to cover your financial needs. This is because you don’t need to pay any penalties for withdrawing your contributions from Roth IRA.

  1. Personal Loan

Finally, you can consider taking out a personal loan if you need to access your funds but don’t want to take a loan from your retirement account. This is generally more affordable than taking money out of 401(k). And you won’t have to worry about any taxes or penalties. However, you should note that you will still have to make regular payments on the loan with interest.

When considering alternatives to a 401(k) early withdrawal, it’s essential to understand all of the risks and benefits of each option. They all come with their own pros and cons. Thus, you should carefully weigh your choices before making a decision. If you’re unsure which option is right for you, consulting a financial advisor can help you make the best decision.

Article written by Rick Pendykoski,

Self Directed Retirement Plans LLC