401(k) Withdrawal Rules: What You Should Know

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 easy, withdrawing funds is often more complicated. Here’s what you need to know in order to make the most of your 401(k).

401(k) early withdrawal rules

A traditional 401(k) plan utilizes both incentives (the “carrot”) and penalties (the “stick”) to encourage saving for retirement, the former including tax advantages and a potential employer match—making this an excellent option for maximizing retirement savings—and the latter associated with early withdrawals.

Early withdrawals, defined as those made before the age of 59½, can trigger a 10% early withdrawal penalty in addition to ordinary income tax on the amount withdrawn. This penalty does not apply to Roth 401(k) accounts, however, whereby you can typically withdraw contributions tax-free at any age (though earnings are sometimes subject to taxes and penalties).

Early 401(k) withdrawal penalty impacts

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, you’ll incur a 10% penalty amounting to $1,000 and need to pay income tax on the withdrawal—reducing your total take-home amount to about $6,500, depending on your tax bracket. The fee itself isn’t the only issue, however, as you also lose out on potential earnings that money could’ve generated had it remained in your account; this is especially true for younger investors due to the power of compounding, which can amount to a sizable chunk of money over time.

For example, if you have $40,000 in your 401(k) and earn an 8% return each year (assuming you don’t make additional contributions), a total of $186,438 will exist in the account after 20 years. If you decide to withdraw $10,000 and therefore only have $30,000, however, this number drops to $139,829 (assuming everything else remains the same). That’s a difference of $46,609, all due to a $10,000 withdrawal!

It's easy to see why early withdrawals are often quite costly. Should you find yourself in a situation where this option is your only choice, know some exceptions to these penalties do in fact exist.

Exceptions to 401(k) early withdrawal penalties

A variety of concessions with respect to the aforementioned penalties include:

Financial hardship

Should you require funds for important expenses, you may be able to withdraw the required money early in the absence of any penalties—noting such hardship withdrawals are typically limited to the amount necessary to meet these urgent financial needs. Examples include medical bills for yourself, your spouse, or dependents; to prevent foreclosure or eviction; college tuition including associated fees, room, and board for yourself, your spouse, or dependents; damage-driven home repairs; and funeral expenses.

Work resignation or termination/layoff

The rule of 55 is an IRS provision that permits individuals to withdraw funds from employer-sponsored retirement accounts without incurring a penalty, although regular income taxes still apply. This rule applies to individuals between the ages of 55 and 59½ and provides access only to funds from a retirement plan you were contributing to at the time you left or were let go.

Terminal illness diagnosis

A terminal illness is defined as a condition for which a physician certifies death is expected within 84 months.

Disability status

You’re considered disabled if you’re unable to perform "any substantial gainful activity" or (according to the IRS) can no longer do the work you performed pre-disability.

401(k) divorce division

A court order is required to divide a 401(k) account in the event of a divorce.

Childbirth or adoption

If you give birth to or adopt a child, you can withdraw up to $5,000 per account from your 401(k) during the same year.

Military active-duty deployment

Military reservists called up to active duty can avoid the early withdrawal fee.

First-time home purchase

First-time home buyers may be eligible to borrow up to $10,000 for the down payment or closing costs.

401(k) rollover

A 401(k) rollover occurs when you move funds out of your 401(k) and into another tax-advantaged retirement account (e.g., an IRA) within 60 days. 

Visit the IRS website for a complete list of 401(k) early withdrawal exceptions that can help you skirt the early 10% penalty; keep in mind you’ll still owe income taxes on these withdrawals, though.

401(k) loan rules

Another way to access 401(k) funds before the age of 59½ is via a 401(k) loan, which many plans permit. If you choose this option, the interest you pay on the loan goes to your account; the loan is not taxable, nor will it affect your credit score.

You can typically borrow up to 50% of your vested account balance or a maximum of $50,000, whichever is lower, and must repay the loan within five years (noting an exception for loans used to purchase a primary residence). If you fail to repay the loan per agreed-upon terms, it may be considered a distribution and thus subject to taxes and penalties.

401(k) withdrawals between ages 59½ and 72

This age range is the sweet spot as you can withdraw money penalty-free during these specific years, although you’re not required to do so. Withdrawal decisions will ultimately depend on several factors—including current employment status, other sources of retirement income, and tax considerations—with traditional 401(k) withdrawals generally subject to regular income tax and reflecting a tax rate determined by your overall income and amount withdrawn. Qualified Roth 401(k) withdrawals are tax-free, meanwhile, allowing for tax diversification in retirement.

Required minimum distributions (RMDs)

After you turn 73 (75, beginning in 2033), you must begin taking required minimum distributions (RMDs) from your 401(k)—with the specific amount based on life expectancy and account balance (click here to read about RMD calculations). Note you must do so by December 31st each year, but a few options are available with respect to taking your very first RMD (e.g., those turning 73 in 2025 can do so by either December 31, 2025 or April 1, 2026). No matter which option you choose, you’d need to take your second RMD by December 31, 2026 in this case.

Failing to take timely RMDs can trigger a substantial 25% penalty (10% if you correct the issue in a timely fashion) on the amount you should have withdrawn.

Early 401(k) withdrawal alternatives

In addition to your checking, savings, and brokerage accounts, you should consider some of the following alternatives that perhaps provide a better option than early 401(k) withdrawals:

Health savings accounts

You can use a health savings account (HSA) to pay for qualified out-of-pocket healthcare expenses such as deductibles and copays.

Personal loans

Another option is to take out a personal loan giving you quick access to funds you can use for any personal expense, shopping around for the best deal on interest rates if you decide to do so. Alternatively, consider asking friends or family for assistance while creating a plan for you to pay them back.

Low or zero-rate credit card

A low or zero-rate credit card is sometimes a viable alternative as well provided can repay your balance within the promotional period, which generally lasts from six to 18 months (depending on the issuer).

Home equity loan or line of credit

If you intend to use the funds for essential home repairs and can afford to repay the borrowed amount, a home equity loan or line of credit is sometimes a sensible option—with the interest on these loans often tax-deductible as an added bonus.

In exploring these options, you may stumble upon a more advantageous way to meet your financial needs without any need to tap into your retirement savings.

In sum: 401(k) withdrawal rules and penalties

Understanding 401(k) withdrawal rules is essential for maximizing retirement savings benefits while minimizing penalties and taxes. Whether you’re planning for early retirement or grappling with the complexities of required minimum distributions (RMDs), careful planning and a solid understanding of these rules can help you make the most of your 401(k) and achieve a financially secure retirement.

Have questions about 401(k) withdrawal rules or retirement planning? Schedule a FREE discovery call with one of our CFP® professionals to get them answered.

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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:
This document is a summary only and is not intended to provide specific advice or recommendations for any individual or business.