It is difficult for many people to treat their retirement savings as untouchable, especially when immediate expenses arise. However, withdrawing early from a 401(k) account can mean sacrificing significant tax benefits on retirement plan contributions that were saved with great effort. It can also put you in a position where you have to pay tax penalties.
Early Withdrawal Penalties from a 401(k) Account
The tax benefits are among the biggest advantages of contributing to a 401(k) plan. Not only is every contribution to a traditional 401(k) tax-deductible, but the money also grows without paying taxes while it is in the plan.
Your contributions reduce your taxable income, thus lowering the amount you owe in taxes in the year you contribute. You will defer paying income taxes on contributions and earnings until you withdraw them.
In fact, it is better not to withdraw money from your 401(k) account until after retirement. You will pay income tax on those withdrawals, but many people find that they are in a lower tax bracket in retirement than they were during their working years when they were claiming tax deductions for their contributions. This can lead to some tax savings.
However, these tax advantages only apply when complying with the plan’s rules. The rules govern everything from how much you can contribute annually to when you can withdraw money from the plan without penalties.
Exceptions to Early Withdrawal Penalties from a 401(k) Account
Several exceptions to the 10% penalty aim to reduce some financial losses in certain cases. Some 401(k) withdrawals made before age 59 1/2 are exempt from the additional penalty under these circumstances:
- You have died, and the account was paid to your beneficiary.
- You have become disabled.
- You have ended your employment and are at least 55 years old.
- You have unreimbursed medical expenses exceeding 7.5% of your adjusted gross income. This may increase to 10% for tax year 2022.
- You have begun taking substantial equal periodic payments. (See Rule 72(t).)
- Your withdrawal is due to a qualified domestic relations order related to divorce.
- You took a qualified withdrawal related to the coronavirus (COVID-19) under the Coronavirus Aid, Relief, and Economic Security (CARES) Act between January 1 and December 30, 2020.
- You took a qualified early withdrawal unrelated to COVID-19 under the Taxpayer Certainty and Disaster Tax Relief Act of 2020 between January 1, 2020, and June 24, 2021.
Note: Withdrawals in each of these last three cases will only be subject to regular income tax and not the additional 10% penalty. However, withdrawals must comply with the plan’s rules and have proper documentation.
Incentives and Other Considerations Regarding Early Withdrawals from a 401(k) Account
It is not advisable to take an early distribution from your retirement plan just because you can – even if you can take one without penalties. There are other important criteria to consider when withdrawing money from an account designated for long-term use.
Investment Growth Potential
You will lose potential future growth of retirement plan funds, along with penalties and taxes owed when withdrawing early. There are annual limits on how much you can contribute to a 401(k) plan, so you cannot offset a prior withdrawal later.
“Catch-up contributions” are allowed for savers over age 50, but it can be very difficult to save enough to recover lost earnings and compound interest by that time.
401(k) Loans
Although 401(k) loans have their own drawbacks, such as needing to make payments with interest, you may want to consider this option if you are in financial trouble, and your only option is your retirement funds. A 401(k) loan could be the better choice instead of a withdrawal with penalties if you have the discipline to make payments on time.
Changes
Withdrawal from 401(k) Under the CARES Act
President Trump signed the CARES Act in March 2020. It is a $2 trillion economic stimulus package aimed at alleviating the health and economic impacts of the COVID-19 pandemic. The law included several provisions allowing for more flexible use of retirement plans like 401(k) plans to help cover emergency expenses, some of which have since expired.
Early Withdrawals Without Penalties
The CARES Act 401(k) stipulates that individuals under 59 1/2 years old can take up to $100,000 in early withdrawals related to COVID-19 from their 401(k) accounts until December 30, 2020, without facing the 10% early withdrawal penalty in the following circumstances:
- You, your spouse, or a dependent were diagnosed with COVID-19.
- Your financial condition was negatively affected due to quarantine, work stoppage, or layoff due to the pandemic.
- You were unable to work due to a lack of childcare resulting from the pandemic.
- You owned or operated a business that was forced to close or reduce hours because of the pandemic.
Note: These special early withdrawal privileges without penalties apply retroactively to COVID-19 related withdrawals made between January 1 and December 30, 2020, which would affect the tax return you file in 2021. They do not apply to withdrawals made on or after December 31, 2020.
Additionally, Congress approved the Tax Relief and Disaster Recovery Act of 2020, which provided this feature for victims of qualified non-pandemic related disasters in 2020. Any individual whose life was affected by a federally declared disaster between January 1, 2020, and February 25, 2021, can take qualified disaster withdrawals of up to $100,000 from their 401(k) accounts until June 24, 2021, without penalties.
Note: You will still owe income tax on early withdrawals from your 401(k) under the stimulus law, but you can pay this portion of your tax liability over three years starting in 2020.
Re-contributing to Your 401(k) Account
The stimulus law allows you to re-contribute to your 401(k) account in one or more payments over three years. These contributions will not count toward the normal annual contribution limits for 401(k).
Borrowing More from Your 401(k) Account
The stimulus law also raised the loan limit from 401(k) accounts from $50,000 to $100,000, up to 100% of the vested account balance, but the loan must be taken from your 401(k) account within six months of the enactment of the stimulus law. The deadline was September 23, 2020.
Note: Unfortunately, the CARES Act did not mandate, but also did not require, plans to offer this higher loan limit. Always check with your 401(k) plan administrator regarding the loan limits that apply to you.
Required Minimum Distributions from Your 401(k) Account
You can delay taking withdrawals from your 401(k) accounts until April 1 of the year following the year you turn 72, or age 70 1/2 if you reached that age before
Source: https://www.thebalancemoney.com/what-you-need-to-know-about-401-k-early-withdrawals-2894147
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