How to Take Money Out of Your 401(k)
Sometimes, it is necessary to consider taking money out of your 401(k) for emergency purposes. Of course, the 401(k) is normally intended to invest money tax deferred that can grow over time and make it so that you can have an income to live off of when you retire from work. However, since the IRS is allowing you to not pay taxes on this money until retirement, they have set certain rules on exactly how you may be able to take money out of your account prematurely and the consequences involved.
A premature withdrawal is normally when you withdraw money before the age of 59 ½. To find out exactly what the options are in your retirement plan account, you will need to contact your plan administrator or the record keeper of your retirement plan account. This is because your employer has set certain guidelines regarding your account under the plan. While they cannot be more lenient than the rules that IRS has set, they can be more restrictive, and that is why it is important to contact them regarding your options. This articles touches on the options that are normally offered for a 401(k) retirement account.
- Difficulty:
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Instructions
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Normally, you can take a loan from your account for the lesser of 50% of your vested account balance or $50,000. There may be a minimum required amount you must borrow, such as $1,000. Therefore, you would have to have a vested account balance of at least $2,000 to take a $1,000 loan. Additionally, some plans only allow one loan at a time, and you must pay off your loan before you can take a new loan, and you may have a waiting period before you can take a new loan. Once you take the loan, you will arrange some kind of repayment plan, which is normally taken directly out of your paychecks after taxes over a set number of years. You will probably have up to five years to pay off the loan, unless you can provide documentation that you are taking the loan to help with the purchase of your primary residence, in which case you might be allowed longer to pay off your loan.
One of the consequences of taking a loan from your 401(k) is that the amount you borrow will not be invested and growing during the period the money is not repaid. Also, the payments are being double taxed because your repayments are after-tax payments, and when you eventually permanently withdraw the money again, it will be taxed at that point as well. Finally, if you are unable to pay off your loan for reasons like losing your job, your loan will go into default. This does not affect your credit, but the amount you did not repay will be treated as a taxable distribution, and you will owe the IRS income taxes plus a 10% early withdrawal penalty if you are under the age of 59 ½.
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If you make after-tax contributions to your 401(k) plan, your plan might allow you to take a permanent withdrawal of the after-tax portion of your account balance without any kind of tax consequences. This means that you will not and cannot pay back the withdrawal, so you will be realizing any loss or gain of the sale of your investments. If your plan allows you to also withdraw any earnings on your after-tax contributions, you will owe taxes on the earnings. For example, if you contributed $1,000 and earned $100 and you withdraw the entire $1,100, you will only be taxed on the $100 earnings.
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Once you stop working for your employer, your plan may allow you to withdraw your entire account balance, but there are tax consequences. If you retire from your employer in or after the year you turn age 55, you can take a withdrawal without an early withdrawal penalty. Therefore, you will only be subject to income taxes. However, if you retire before the year in which you turn age 55 and you take a permanent distribution, you will be subject to income taxes plus a 10% early withdrawal penalty.
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While you are still working for the employer that sponsors your retirement plan account, you may be able to take withdrawals beginning at the age of 59 ½ without the 10% penalty. Only the income taxes will apply.
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If you are still working for your employer and are under the age of 59 ½, you may only be allowed to take a permanent withdrawal due to a hardship if you qualify. You will normally be required to take all possible loans from your account before you can take a hardship withdrawal. The types of things the IRS has deemed as a qualifying hardship situation include unreimbursed medical expenses for you, your spouse, or your dependents; for the purchase of your primary residence; for the payment of college tuition and related expenses for you, your spouse, or your dependents; to prevent eviction or foreclosure from your home; to pay for funeral expenses; and to pay for home repairs.
Of course, it is more complicated than it sounds. Applying for a hardship withdrawal is normally a long process of completing an application and providing specific documentation proving your hardship situation and the exact amount you need. If your request is approved, you will be subject to income taxes and a 10% early withdrawal penalty for the year you took the withdrawal.
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Finally, once you reach the age of 70 1/2, you will be required to take a minimum distribution from your account every year. There will be a set amount you must withdraw and there are consequences if you do not take the withdrawal. This is because the IRS is looking to finally cash in on the taxes that you deferred for all those years! You will need to contact your plan about the specific rules and processes for taking money from your retirement plan account.
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There are a few exceptions to the early withdrawal penalty. To find out more information about the tax consequences of withdrawals from a 401(k), you will need to refer to the Special Tax Notice Regarding Plan Payments using the link under Resources below.
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Tips & Warnings
It is important to refer to your plan's requirements about loans and distributions because they may be more restrictive than what I mentioned above.
When taking a loan or withdrawal, ask about the limits on future loans and withdrawals. You may only be able to take one for a specified period of time.
Try to make 401(k) loans and withdrawals a very last resort, as the consequences to taking money out prematurely are heavy.
