Every now and then, people find themselves in a situation where they need to tap into their 401(k) accounts. Whether it’s to cover unexpected medical expenses like dental surgery, make a down payment on their first home, or address other pressing financial needs, accessing retirement savings can sometimes feel like the only option. However, withdrawing from a 401(k) comes with important considerations, including potential taxes, penalties, and long-term financial impact. This article provides a clear, step-by-step guide to help you understand your options and make informed decisions before taking money out of your retirement account.
In general, it’s best to evaluate your options in the following order: Hardship Withdrawal, 401(k) Loan, and, as a last resort, a 401(k) withdrawal with penalties. This approach helps minimize unnecessary fees and long-term financial setbacks. Keep in mind that this guide is specifically for individuals under 59 1/2 years old, as those above this age can withdraw funds without facing an early withdrawal penalty. Understanding these options can help you make the best financial decision while preserving your retirement savings as much as possible.
Hardship withdrawals are generally allowed only for “heavy and immediate” financial needs, and these are pretty strictly defined by the IRS. Medical expenses can sometimes qualify, but it usually needs to be for yourself, your spouse, or your dependents. Hardship withdrawals do not come with any penalty though you still need to pay income tax for the withdrawl. Whether getting dental work done in Spain would qualify might be tricky, and you’d need to check the specifics of your 401(k) plan. If your HR approves this as ‘hardship’, it might be OK. This should be the first option to consider if you need money from your 401(k) retirement account.
A 401(k) loan might be an option if your plan allows it. The cool thing about a loan is that you’re essentially borrowing from yourself, and the interest you pay goes back into your 401(k). You can generally borrow up to $50,000 or 50% of your vested account balance, whichever is less [0]. You’ll need to make regular payments, usually through payroll deductions. Just remember, if you leave your job, you’ll likely have to repay the loan pretty quickly, or it’ll be considered a withdrawal, and you’ll face those taxes and penalties. This should be the second option to consider.
Early withdrawals, in general, are possible, but they come with a cost. You’ll typically have to pay income tax on the amount you withdraw, and if you’re under 59 1/2, you’ll likely get hit with a 10% penalty from the IRS. So, taking out $4,000 could end up costing you quite a bit more after taxes and penalties. This should be the last option to consider.
Important Note: It’s often debated whether a 401(k) hardship withdrawal or a 401(k) loan is the better option. If you have the ability to repay the loan over time, taking a 401(k) loan is generally preferable. This is because repaying the loan allows you to restore your retirement savings, whereas a hardship withdrawal permanently reduces your retirement balance. Additionally, a hardship withdrawal is subject to income tax, whereas a loan is not—helping you avoid an immediate tax burden.