The purpose of saving money in a 401(k) plan is to accumulate enough cash to cover your living expenses in retirement.

The benefit of 401(k)s is they allow you to save in a tax-advantaged fashion.

As such, the IRS imposes some pretty strict rules on withdrawals — namely, that you generally have to wait until you turn 59-1/2 to get at that money, or otherwise face a 10% penalty.

Here, we’ll show you how you can access your 401(k) funds without getting hit with a penalty in the process.

How 401(k) plans work

A 401(k) plan allows you to set aside funds for retirement in a tax-advantaged manner. There are two types to choose from: traditional and Roth, though the latter option may not be available in all plans.

With a traditional 401(k), your contributions are made with pre-tax dollars, so there’s immediate savings involved — if you put in $8,000 in a given year, that’s $8,000 of income the IRS can’t tax you on. The money you stash in your 401(k) can then be invested for tax-deferred growth — meaning, you don’t pay taxes on gains in your account year after year. Rather, you pay taxes upon taking withdrawals in retirement, which you can do penalty-free starting at 59-1/2.

With a Roth 401(k), your contributions are made with after-tax dollars, so you don’t get the same up-front tax break as with a traditional 401(k). But the money you invest in that account gets to grow completely tax-free, and withdrawals are also tax-free in retirement.

401(k) early withdrawal penalties

Because the IRS offers lots of tax incentives to save in a 401(k), it also dictates that you can’t withdraw your money prior to age 59-1/2. If you do, you’ll face a 10% early withdrawal penalty on the sum you remove. Take a $10,000 early withdrawal, and that’s $1,000 you’re losing off the bat.

Furthermore, if you take an early withdrawal from a traditional 401(k), you’ll pay taxes on the amount you remove. That’s not a penalty — you’d pay the same taxes if you were to take that withdrawal after 59-1/2 as well. But it’s something to be aware of.

Exceptions to the early withdrawal penalty

In some cases, you can access your 401(k) funds prior to age 59-1/2 without incurring a penalty in the process. Here are few potential exceptions:

  • Medical expenses. If you have a lot of medical expenses in a given year, you may have no choice but to tap your 401(k) to cover them. You can avoid an early withdrawal penalty if you remove funds from your 401(k) to cover medical expenses exceeding 10% of your adjusted gross income.
  • Permanent disability. In the very unfortunate event that you become permanently disabled, you can take an early 401(k) withdrawal without being penalized.
  • Military reserve duty. If you’re a qualified reservist and are called to active military duty for 180 days or more, you can take a penalty-free early 401(k) withdrawal.
  • Court mandates. If a court of law orders you to give a former spouse or dependent money from your 401(k), you won’t be penalized for following that directive, even if you’re not yet 59-1/2.
  • The Rule of 55. If you leave your job at age 55 or older, and the employer in question is the one sponsoring your 401(k), you can cash out your 401(k) without incurring penalties. But that only works if you wait until you’re at least 55 to separate from your employer. You can’t retire at 53, wait two years, and then cash out your 401(k).
  • Rollovers to qualified retirement accounts. When you roll your 401(k) funds into another qualified, tax-advantaged retirement account, you don’t incur a penalty. This means that if you leave your job and roll your 401(k) into your new employer’s 401(k), you’re fine. The same holds true if you roll your 401(k) into an IRA. Even if you don’t directly roll your 401(k) into another qualified plan, you’ll avoid penalties with an indirect rollover (meaning, you get a check and deposit it into your new account, as opposed to having those funds transfer automatically) if you complete it within 60 days.
  • Substantially equal periodic payments. Substantially equal periodic payments let you access your 401(k) funds early without a penalty. You’ll benefit from this provision if you withdraw funds from your 401(k) at least once a year for a minimum of five years, or until you reach 59-1/2 — whichever is longer. You can calculate these payments via one of three methods: 1) The RMD method, where you use IRS life expectancy tables to calculate your lifespan and divide your account balance by that amount; 2) The fixed amortization method, where you apply an IRS-approved interest rate to your account balance and draw it down over the course of your life expectancy; 3) The fixed annualization method, which uses an IRS-approved annuity factor and interest rate to determine your annual draw-down. Note that the latter two options give you the same withdrawal payment year after year.

401(k) withdrawals that don’t qualify as an exception

Many people who save for retirement in an IRA opt to withdraw their funds early to pay for higher education or purchase a first-time home. In these cases, the 10% early withdrawal penalty doesn’t apply.

The rules are different for 401(k)s, though. If you withdraw funds prior to age 59-1/2 to buy a first-time home or fund a college education, you’ll still be hit with an early withdrawal penalty. As such, it pays to look into setting up a dedicated college savings plan, like a 529, to avoid having to tap your 401(k) for education purposes. And if you’re aiming to buy a home and need a down payment, cutting back on expenses in your budget and socking away funds in a savings account is your best bet.

401(k) hardship withdrawals

Some 401(k) plans allow savers to make what are known as hardship withdrawals, which make funds accessible due to pressing financial circumstances. These may include:

  • Medical bills
  • Funeral expenses
  • Home repairs
  • Preventing foreclosure
  • Purchasing a home
  • Educational expenses

Notice that some 401(k) plans approve hardship withdrawals; it’s not a given, nor is it a given that your plan will count all of the above categories as valid in this regard. For example, your plan’s rules might state that medical bills or funeral expenses count for hardship withdrawal purposes, but education expenses don’t. Furthermore, a hardship withdrawal doesn’t necessarily get you out of paying the 10% penalty for removing 401(k) funds early — in some cases, it just makes that distribution a possibility.

Now the rules used to be that once you took a hardship withdrawal, you couldn’t contribute funds to your 401(k) for another six months. And, you couldn’t tap the gains portion of your 401(k) to access funds for a hardship withdrawal. Rather, you were limited to the principal contributions that came out of your earnings.

But recent changes to the rules now dictate that you may be entitled to continue contributing to your 401(k) following your hardship withdrawal without that six-month waiting period, and that you can in fact access funds from the gains portion of your account as well. Ultimately, you’ll need to check and see what your plan allows for. And also, remember that you’ll need to prove to your plan administrator that you’re experiencing a financial hardship to qualify for this type of withdrawal in the first place.

Don’t forget that if you’re taking a hardship withdrawal from a traditional 401(k), you’ll be subject to taxes on your distribution. Again, this is not a penalty — it’s just what happens when you remove funds from a traditional retirement savings plan.

Required minimum distributions

When we talk about penalties relating to 401(k) distributions, it’s easy to focus on early withdrawals. But actually, waiting too long to remove funds from your 401(k) could land you in the same boat: penalty-central.

Whether you have a traditional or Roth 401(k), once you reach age 70-1/2, you’re required to remove a certain portion of your account balance each year, or otherwise face a whopping penalty. That portion is known as your required minimum distribution, or RMD.

Why are RMDs necessary? It’s simple: The money in your 401(k) gets to grow in a tax-advantaged fashion, and the IRS doesn’t want you to enjoy that tax break forever. It also wants to ensure that you deplete your retirement plan balance in your lifetime, as opposed to leaving that money to your heirs who would then, in theory, get to benefit from tax breaks as well. As such, RMDs create a scenario where you’re slowly but surely depleting your 401(k) balance, whether you want to or not. (Incidentally, RMDs apply to traditional IRAs, too. The only retirement savings plan that doesn’t impose RMDs is a Roth IRA.)

Your exact RMD will depend on your 401(k) balance coupled with your life expectancy the year you’re taking it. There are online tools you can use to determine what your RMD looks like, or if you have a financial advisor, he or she can calculate it for you.

Your first RMD must be taken by April 1 following the year you turn 70-1/2. If you turn 70 in May 2020, and turn 70-1/2 in November 2020, your first RMD is due by April 1, 2021. If you don’t turn 70 until August 2020, you won’t have to take an RMD until 2022. Once you’ve taken your initial RMD, all subsequent withdrawals are due by December 31 of each calendar year.

If you don’t take your RMD in full or at all, you’ll be hit with a 50% penalty on the amount you neglect to remove. Fail to take a $7,000 RMD, and the IRS gets $3,500 of your money.

The only exception to this rule is if you’re still working for the company that sponsors your 401(k) by the time RMDs come into play, and you don’t own 5% or more of that company. In that case, your RMDs are pushed off until you leave that job. That isn’t the case with traditional IRAs — working longer won’t get you out of taking them.

Not only do RMDs limit the extent to which your money can grow in a tax-advantaged fashion, but they also create a potential financial burden when you’re dealing with a traditional 401(k), since withdrawals of any kind are taxed. Though Roth 401(k)s impose RMDs as well, you don’t have to pay taxes on those withdrawals, so there’s less of blow.

401(k) loans

Removing funds from your 401(k) for non-retirement purposes is pretty much never a good idea. But if you have no choice but to tap that account prior to age 59-1/2, you’re better off removing funds in the form of a loan than taking an early withdrawal. With a 401(k) loan, you don’t pay a penalty unless you’re unable to repay your loan as per your plan’s requirements.

Now to be clear, not every 401(k) plan allows participants to take out loans, just like plans set their own rules for hardship withdrawals. But if your plan does let you take out a loan, you can generally borrow the lesser of up to $50,000, or 50% of your vested plan balance. That said, some plans let you borrow up to $10,000 even if that sum falls below the 50% limit. For example, if you have $18,000 in your 401(k), your plan might allow for a $10,000 loan when you’d otherwise be limited to $9,000.

Usually, you’ll get five years to repay your 401(k) loan, and while you will have to tack on interest, that’s not such a raw deal, since that interest gets paid back to your own account. But here’s the catch — if you don’t repay your loan on time, it will be treated as an early withdrawal. And you know what that means — you’ll face that dreaded 10% penalty, plus taxes on your distribution in the case of a traditional 401(k).

Another thing you should know is that once you separate from your employer, the repayment period on your 401(k) loan may be accelerated to as little as 90 days. This means that if you’re let go from your job with a $15,000 outstanding loan balance, you’ll have just three months to repay it or risk the aforementioned penalty. As such, while a 401(k) loan may be preferable to an early withdrawal, it’s not a great road to go down.

Leaving your 401(k) alone

All this time, we’ve been talking about accessing money from a 401(k) ahead of age 59-1/2. But really, that’s not a great thing to do.

The money in your 401(k) is supposed to be earmarked for retirement, and the more of it you remove along the way, the less you’ll have when your career ends and you really need that cash to pay your living expenses.

Most seniors, in fact, are advised that they’ll need 70% to 80% of their former income to cover their bills in retirement, and Social Security will only replace about 40% of the average earner’s former wages. As such, you’ll likely need a hefty 401(k) balance to ensure that you can live comfortably, and the more money you withdraw in advance of retirement, the less you’ll have in your account when you need it the most.

Furthermore, when you take an early 401(k) withdrawal, you don’t just lose out on the principal sum you remove; you also lose out on potential growth on that sum. Imagine your 401(k) is invested in a manner that generates an average annual 8% return. (That’s certainly doable if you load up on stocks, since the stock market’s historic average annual return is around 9%).

Now, let’s say you take a $10,000 withdrawal at age 45 and retire 20 years later. At an 8% return, you’re looking at a loss of roughly $36,600 in gains. In other words, you won’t just be short $10,000 in retirement by taking that early withdrawal; you’ll be short $46,600, which is a much bigger deal.

That’s why it really pays to leave your 401(k) plan alone, and you can do so by exploring the following alternatives to accessing cash when you need it:

  • Emergency savings. Most workers are advised to set aside enough money in the bank to cover three to six months of essential living expenses. Cut back on spending or get a second job to boost your cash reserves to build a solid emergency fund for yourself. That way, you’ll have options for covering unforeseen expenses, like medical bills, that might otherwise prompt you to raid your retirement savings.
  • A home equity loan. If you have at least 20% equity in your home (meaning, you own that much outright), you can generally borrow against that equity quite affordably. Home equity loans tend to have favorable repayment terms, and they’re easy to qualify for, since your home is used as collateral to ensure that your lender gets repaid one way or another. As such, they’re a smart alternative to early 401(k) withdrawals or even 401(k) loans.
  • A personal loan. If you have good enough credit, you may qualify to borrow money in the form of a personal loan from your bank. The interest rate attached to that loan may be higher than that of a home equity loan, since you’re not putting up a piece of property as collateral, but it’s a viable option to consider nonetheless.
  • Liquidating assets. If you’re sitting on a non-tax-advantaged investment portfolio (like a traditional brokerage account), selling assets from it could do the trick of freeing up cash without you having to touch your 401(k) ahead of retirement. If you sell those assets at a gain, you’ll be subject to taxes on your profits, but if you sell assets at a loss, they’ll actually serve as a tax deduction for you.

Waiting has its benefits

When you need money quickly, it’s very tempting to access the funds sitting in your 401(k). After all, that money is technically yours. But as discussed many times over, early 401(k) withdrawals can be costly, and they can also hurt you once you enter retirement, so rather than take one, aim to hold off until at least age 59-1/2. And if you’re not retiring at 59-1/2, wait even longer — ideally, until you actually bring your career to a close and stop collecting a paycheck from work. That way, you’ll give your money more time to grow, and you’ll be looking at a higher savings balance for your golden years.

— Maurie Backman

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