Although I’m a full-time freelancer now, I remember the days of receiving pay stubs — reading that neat little list of all the places my money was going.
Mostly, I remember how many of those places weren’t my pockets. Federal and state taxes, social security, health care… and, yes, a percentage of my wages deferred to my 401(k), funneled directly toward my hope of future retirement.
This is a personal finance blog you’re reading, so we probably don’t have to reiterate the importance of retirement savings. (Even though we just did.)
But as responsible and saving-savvy as you might be, you probably still want to know: How — and when — can you get those 401(k) contributions back out again?
What’s a 401(k), Anyway?
Before we start talking about how to take money out of your 401(k), let’s talk about how it gets in there in the first place. What is this bowl of alphabet soup, anyway?
A 401(k) is a company-sponsored investment account designed to help you save money for retirement — and it gets you a tax break today, too. You set up a portion of your wages, usually expressed as a percentage of your overall salary, to be automatically deposited, or “deferred,” to your 401(k).
Then, you invest the assets and allow them to grow on the market, slowly but surely building up your nest egg you need to eventually throw in the towel. (Oh, and you won’t pay income taxes on those funds until you take them out, either!)
The really cool thing about 401(k)s is that, unlike many other retirement accounts, your employer can also make contributions — and many employers do, up to a certain percentage of your wages.
This is called an “employer match,” and it basically means free money: For every dollar you defer up to the designated percentage, your employer will put in another, which is a super-easy way to increase your retirement savings.
We don’t have time in this post to go into all the nitty-gritty details about how a 401(k) works, and regardless, you’ll need to check with your company for specifics.
Now let’s talk about how to access your contributions — and capital gains — after you invest them.
Withdrawals, Distributions and Penalties, Oh My!
If you were to head to the IRS website to try and learn more about 401(k) withdrawal rules, you might end up scratching your head. The word “withdraw” doesn’t appear even once in the resource guide.
But fear not: Your 401(k) funds aren’t actually locked away forever. The government just likes to keep things interesting by opting for very specific terminology.
A 401(k) withdrawal is known, in IRS-speak, as a distribution. And there are very specific rules regarding when distributions can be made.
In general, you won’t be able to take money out of your 401(k) — at least, not without incurring a penalty — until one of the following things happens:
- You reach age 59.5. (You celebrate half-birthdays, right? The IRS is very fond of them.)
- You die, become disabled, or “otherwise have a severance from employment,” which is ominous-sounding, indeed.
- Your employer terminates the plan or goes out of business.
If you withdraw your money outside of these circumstances, you’ll be hit with a hefty penalty: a 10% early distribution tax, along with the regular income taxes.
As if that weren’t enough, there are also rules about when you must make withdrawals. You’re not allowed to let your 401(k) contributions grow forever.
Once you reach age 70.5, you must begin taking required minimum distributions (RMDs) from your 401(k) account, unless you are — heaven forbid — still working.
It might feel stifling, having your money restricted by so many ironclad rules.
After all, you earned it, and you did the budgetary shuffling required to afford to put it away. Why shouldn’t you be able to take it out whenever you want to?
Well, for one thing, ripping your retirement savings out of your account is a surefire way to miss out on compound interest, which is how you’re going to turn that measly 3% of your paycheck into a livable retirement income.
And since you’re getting a tax break, the government’s not too keen on having you withdraw your funds willy-nilly.
But there are certain exceptional circumstances in which you can take distributions even if you’re nowhere near your 60th birthday.
What Are the Exceptions?
As strict as the tax code may be, it’s not entirely without humanity. You can make penalty-free distributions from your 401(k) in the following circumstances:
- You have, or develop, a qualifying disability.
- You leave your job and the company agrees to remit periodic payments for at least five years, or until you reach the age of 59.5.
- You’re required by court order to pay the money to your divorced spouse, child, or dependent.
- You’re paying for medical expenses that qualify for an income tax deduction. The IRS allows you to deduct medical costs that exceed 10% of your AGI, or adjusted gross income (7.5% if you or your spouse is over 65). For example, if your AGI is $30,000, you’d be able to withdraw only enough to pay medical expenses over $3,000, or $2,250 if you’ve already celebrated your 65th birthday.
- You’ve weathered a disaster for which IRS relief has been granted.
- You die (?), in which case the distributions are made to a beneficiary.
You can also take early withdrawals, known as “hardship distributions,” from your 401(k) if you can demonstrate you’re under certain types of serious financial burden.
However, hardship withdrawals are limited to your elective deferrals only — that is, you can take out the money you put into the account, but not any of the investment gains you might have earned in the meantime.
(It’s up to your employer whether or not you can take out any of those matching funds we discussed earlier, or any other discretionary contributions made by your company.)
You should also note that you’ll still be required to pay income taxes on the distribution — and, if you’re not yet 59.5, the 10% penalty will still apply.
What Qualifies for a 401(k) Hardship Withdrawal?
The No. 1 criterion for qualifying for a hardship withdrawal is “immediate and heavy financial need.” The IRS outlines the following instances where this kind of need may arise:
- You, your spouse, or your dependents incur medical expenses.
- You need money to cover costs related to the purchase of your principal residence — but this does not include mortgage payments.
- You’re footing the bill for higher education costs for you, your spouse, your children or your dependents, including tuition, fees, room and board.
- You need money to avoid being evicted from your home or having your mortgage foreclosed.
- You’re faced with funeral expenses.
- You need to repair certain damages to your principal residence.
It’s important to note that your employer ultimately decides whether or not you can take a hardship withdrawal from your 401(k) plan at all, no matter what your financial deal is.
And if you do take money out, you may be unable to make further contributions for a period of six months thereafter.
It’s also possible to borrow from your 401(k) — but just like any other loan, it must be repaid, on time and with interest.
If you fail to meet the terms of your 401(k) loan, the amount you owe back to the plan will become a distribution, and will thus be subject to the same taxes (and early withdrawal penalty) as it would have been if you’d taken it without the intention of repaying it.
Just as with hardship distributions, it’s up to your employer and 401(k) custodian as to whether or not loans are allowed. If they are, you’ll be able to take a maximum of 50% of your vested account balance (i.e., funds you actually own, which may include employer contributions) or $50,000, whichever amount is lower.
In most cases, you’ll have five years to repay the loan, unless it’s being used toward the purchase of your primary residence.
If you meet these requirements, however, the loan is not considered taxable income… but you definitely want to make sure you can pay it back on time!
What is the “Age 55” Rule?
If you’re almost, but not quite, at the age of retirement, these rules can feel even more stifling — which is why the IRS has implemented a special clause for savers aged 55 and older.
If you’re laid off, fired, or quit your job during or after the year of your 55th birthday, you get to make penalty-free distributions from your 401(k) plan… but only the one you were most recently invested in. That is, if you have other 401(k) accounts languishing from previous positions, you still won’t be able to access those funds until you reach the normal retirement age.
Which is one good reason to roll over your retirement account whenever you change jobs. Speaking of which…
Moving On: 401(k) Rollovers and Transfers
You might even be considering cashing it out so you can walk into your new life with a windfall. (We’d recommend you don’t, for reasons we’ll dive into in just a second.)
Although it’s not the same as withdrawing the money to be used from your own pocket, rollovers and transfers are another way to move your 401(k) funds — and given how frequently most of us change positions these days, it’s important to understand your options.
Here’s what you can choose to do when you’re leaving a job with a 401(k).
Probably the easiest way to deal with a dangling 401(k) is to simply roll it over into your new job’s plan — granted your new job has an eligible plan in the first place. (If you’re moving to a position that doesn’t offer a 401(k) or other compatible retirement benefit, you can roll the funds over into a traditional IRA.)
In a direct rollover, you never get to see the money — your existing plan’s custodian simply routes the money directly over to the new account manager. As such, you won’t have to worry about paying any income taxes or being assessed the early withdrawal fee, because you never have spending access to the funds in the first place.
Indirect Transfer or Rollover
Another option for bringing your 401(k) along with you to your new job is to do an indirect transfer, or rollover.
In this case, you actually do cash out your existing account, but with the intention of putting all the money right back into some other retirement-specific investment vehicle.
As long as you redeposit your entire account balance within 60 days of withdrawal, you’ll avoid paying any taxes or penalties.
However, there is one small fly in the ointment: Your existing account custodian is required by law to withhold 20% of the distribution, regardless of your good intentions… which means you’ll have to make up the difference out of your pocket when you fund the new account.
The money will eventually come back to you as a tax refund — but depending on the size of your 401(k), you might not have the funds to break even in the meantime.
And if you don’t redeposit the entire balance within the 60-day window, you’ll face those same early withdrawal penalties we’ve been discussing throughout the post, not to mention income taxes.
Take the Money and Run
Yes, you can cash out your 401(k) when you leave your job.
But if you do, again: You’ll pay the 10% penalty and add the windfall to your taxable income for the year.
And even worse, you’ll also be stripping yourself of one of the most powerful retirement savings devices at your disposal.
If you ever want to punch the clock for the very last time, you need to have some sort of investment vehicle… unless you’re independently wealthy or something. (In which case, you should still stash the money in a regular investment account so it can grow even more!)
Leave It Where It Is
Another option? Simply leave the funds where they are — as long as your company allows it. (If you’ve only worked there a short time or your account totals less than $5,000, they may force you to take it with you.)
Different 401(k) plans have different policies, fees and investment options, so if you’re happy with what your former company offers, you might let the money languish there and continue growing.
Of course, if you switch jobs, say, 10 times in your life and take this tack at each turn, you’ll end up with a scattered mess of a retirement portfolio — and as discussed above, you won’t be able to take full advantage of the age 55 rule.
Taking advantage of your company’s 401(k) plan is one of the very best ways to set yourself up for a comfortable retirement. These investment accounts carry lots of special incentives, including high contribution maximums as well as their tax-deferrable status.
But we get it: Life is expensive! And sometimes, you don’t have the cash you need to get through the present day, let alone some nebulous future moment.
Whenever possible, it’s best to leave your 401(k) funds invested and growing. Compound interest requires time to do its best work, and making early withdrawals can wreak havoc on your nest egg’s potential. It may take hard work and discipline, but future you is counting on your determination!
If you do need to take distributions from your 401(k), however, we hope this guide has offered some clarity as to how, when and why best to do so. (But really: Don’t. We mean it.)
Jamie Cattanach’s work has been featured at Fodor’s, Yahoo, SELF, The Huffington Post, The Motley Fool, Roads & Kingdoms and other outlets. Learn more at www.jamiecattanach.com.