Withdrawing money from a 401k before the approved age of 59½ years old can sometimes feel like an arduous task. Hardship withdrawals often feel like the only way to get your money out before time. Can you withdraw early without hardship?
You can withdraw from 401k early without hardship, but you’ll likely pay a 10% withdrawal penalty. The IRS will also withhold 20% of the amount withdrawn for taxes. Combined, this means you stand to lose 30% of any amount you withdraw early from a 401k without hardship.
Let’s dive into all you need to know about early withdrawal from 401k without hardship.
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Table of Contents
What is Hardship Withdrawal?
Hardship withdrawals refer to money taken out of your 401(k) to take care of a personal situation. The amount withdrawn has to be within the limits of the actual financial hardship.
The IRS determines what qualifies as financial hardship. Based on their guidelines, hardship withdrawal is only allowed for:
- Certain medical expenses
- Burial or funeral costs
- Tuition and other educational expenses
- Payment towards certain home repairs, purchasing a home, or preventing eviction
The withdrawals aren’t tax-free. You may have to pay 10% tax on each one, but there are no other penalties. In some cases, you may qualify for a tax waiver as well. Side note: Hardship withdrawals are allowed by the IRS, but they aren’t automatically allowed on all 401(k) plans. Providers can have different rules, so check your documents carefully.
What Happens if You Withdraw Early Without Hardship?
While it’s possible to withdraw early without hardship, you’re likely to attract penalties in addition to withheld taxes. Early withdrawal also reduces your retirement fund. You’ll miss out on returns achievable on the withdrawn money.
Automatic Taxes
If you withdraw from 401k early without hardship, the IRS will automatically withhold 20% of the sum for tax purposes. So, if you withdraw $20,000 early, you’ll only get $16,000. You may get back some of the $4,000 lost to taxes in refunds if you qualify, but at the time you need the money, you’ll only get 80% of the sum.
Early Withdrawal Penalties
The percentage you’re left with falls further with the 10% penalty fee levied on all early withdrawals before you clock 59½ years of age. So, in the example above, you’ll lose a further $2,000 to bring the total take home to around $14,000. That’s 30% of the withdrawn sum lost to penalties and taxes.
Lost Returns
Taking out $20,000 from your 401(k) also means you’ll likely have less money in your plan than you should at the time of retirement. It’s especially true if the market continues to make new highs until your retirement age. A 90% return on $100,000 beats a 90% on $80,000.
Of course, you can offset this by putting back more money as soon as you can, but it may not be enough. Most plans won’t allow putting a lump sum back. You’ll also likely lose money if you withdrew in a bear market and missed out on matched payments from your employer.
How to Withdraw Early Without Hardship and Avoid Penalties and Taxes?
If you still want to withdraw early but your situation doesn’t qualify as a hardship withdrawal, there are a few options for you.
Check if You Qualify for Penalty Exemption
The IRS will typically waive the penalty on the withdrawal in the following scenarios:
- You lost your job. You’ll only get the exemption if you lost your job around your 55th birthday or later. The age limit is 50 for people in certain government jobs like border protection, firefighting, federal law enforcement, etc.
- You have to split the 401(k) after a divorce. If the court order in your divorce cases requires you to cash out your 401(k) after a divorce, you likely won’t pay penalties on the withdrawal.
- You agree to receive equal periodic payments. Under this arrangement, you’ll agree to take some equal payments after you stop working. The payments will continue for life like some sort of annuity. This option is a bit more complex, with numerous rules. Talk to a professional to weigh your options here.
Below are other scenarios that may qualify you for early withdrawal without penalties:
- You need the money to pay an IRS levy.
- You recently adopted a child or gave birth to yours.
- You’re disabled or just became disabled.
- You were affected by a disaster for which the IRS has provided relief.
- You want out of an auto-enrolled 401(k) (time limits apply).
- You’re a military reservist that’s just been called to active duty.
Convert the 401(k) to an IRA
Individual retirement accounts (IRAs) typically have different withdrawal rules compared to 401(k)s. So, converting to an IRA first might save you the 10% early withdrawal penalty.
There’s also no mandatory tax withholding on IRA withdrawals, so you’re almost certain of a bigger check. You’ll still pay the tax when it’s time to file returns, but you’ll have more money to deal with the situation in the immediate term.
It’s a perfect option to go with for those in a lower tax bracket sure of getting refunds.
However, before switching to an IRA, you need to make sure you understand the peculiarities, including fees.
Only Withdraw the Minimum Amount
While this approach won’t technically help you avoid penalties and taxes, it can help you minimize the impact overall. You should only withdraw the exact amount you need for your emergency.
Don’t add an extra 30-50% to cover taxes and penalties if you can afford to replace any amount lost to penalties from your pocket.
Remember, you’ll stunt your retirement income with every withdrawal. Similarly, you should only ever withdraw from your 401(k) in a real emergency. It’s counter-productive to withdraw from your 401(k) for a luxury purchase or even to pay off debt.
Alternatives to Withdrawing Early from Your 401(k)
If you’ve gone over the details above and have decided to leave your 401(k) untouched, there are a few other ways to raise money to consider.
Take a Home Equity Loan
If you own a home, you can consider going with a home equity loan instead. You’ll need at least 20% equity to secure the loan. The average interest rate on these loans is around 5.33%, which is much better than the rates on other forms of financing (like credit cards). You should also note that there are no tax deductions unless you’re reinvesting the loan into your home.
Go With Cash-Out Refinance
With this option, you’ll refinance your mortgage and get cash out at closing. By taking this approach, you’ll increase your mortgage balance and increase the mortgage term. Before choosing to refinance, you should compare your current interest rates against the prospective interest rate following a remortgage.
Get a Personal Loan
Depending on your financial situation, a personal loan may be a better option to go with instead of taking money out of your 401(k). It may also beat other alternative sources we’ve covered here. However, the interest rates are usually higher because the loan isn’t tied to any collateral.
The rates can be as low as 6% or as high as 36% because the lender shoulders the bulk of the risk. The interest rate charged will likely be influenced by your credit rating.
Get a 0% APR Credit Card
A 0% APR credit card will likely get you the funds you need, but you need to have good-to-excellent credit to be approved for one of these. You also need to be sure you can repay the balance in full before the 0% APR period ends. The average term on most of these cards is 18 months, but some providers may offer more or less time.
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Conclusion
You can withdraw early from 401k without hardship, but you should be prepared for the taxes and possible penalties. You may avoid the penalties and taxes if your situation qualifies you for an exemption.
However, experts recommend avoiding any kind of withdrawals from your retirement accounts because there’s a risk of disrupting your long-term financial situation. Talk to a qualified financial adviser to weigh up your options.
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