Life can be difficult sometimes. It can be pretty hard finding just the right budget for your monthly needs. Maybe you’re behind on some car payments, or your landlord just told you that the rent went up. But hey, you remember that you’ve been investing part of your monthly paycheck on a 401(k) plan for a while now and the proceeds can bail you out.
The problem is, you’re not 59 and a half years old yet, so you’re not eligible to get the whole thing. You’ll have to worry about 401k early withdrawal penalties. But what penalties and fees are there to worry about? How do you avoid them? What even is a 401(k)? Let’s dig deeper.
The 401k Plan And How It Works
In the most basic terms, the 401(k) plan is a form of investment that you pay for as an employee. The contributions you give are taken directly from your paycheck and are tax-deductible. You can choose which investments to put the money to, depending on what’s available in the plan. The money you put in here helps with your retirement plan.
Sometimes, your employer may even match some percentage of what you contribute to help you out. That’s not always the case, but a lot of employers do this. You can only contribute about $19,500 a year (as of 2020), but if you’re older than 50, you can add an extra $6,500 to your annual contributions.
Generally, there’s not much to think about once you’ve set this all up. It’s a pretty convenient way to invest your hard-earned money to have a good retirement later on. On the other hand, though, if you managed to get a raise, you may want to take a second look at your 401(k) plan. If you’re earning more but are still contributing the same amount as before you got your raise, you might be at a huge disadvantage.
401k Early Withdrawal Penalties And Other Consequences
Despite it being an easy way for an employee to invest their money and secure their future, they can’t withdraw their money before they reach 59½ years old. Otherwise, they’ll get a penalty if they do so. But why does there have to be a penalty?
It’s meant to be a deterrent for people to avoid undermining the money they are saving up for retirement. For a lot of people, the only way they can live out a comfortable retirement is when they contribute to this plan every year. It wouldn’t do well if they decide to use what amounts to their retirement money on something short-sighted, like paying credit card bills or paying for a brand-new car. Here are the consequences of cashing out your 401(k) early:
1. 20% Withheld for Taxes
If you cash out before the proper age, the IRS will automatically withhold 20% of your withdrawal amount. This is generally for paying the taxes involved. For example, if you belong to the 24% tax bracket, a $5,000 withdrawal will cost you $1,000 in taxes.
2. 10% Cash-Out Penalty
Aside from the money withheld from tax, you’ll also get penalized by the IRS. When you file your tax return after taking cash out, you’ll be charged a 10% penalty. So, from that $5,000 we mentioned earlier, another $500 will be deducted from the withdrawal. Added to the amount withheld, that’s already $1,500 you won’t be getting from that $5,000.
3. A Less Financially Stable Retirement
Another consequence of cashing out too early is having to deal with less money in the future. This is especially damaging if you decide to withdraw early during a time when the market is down. If you pull funds early, during a recession, it will have an impact on how you will participate during a rebound, causing a huge offset on your retirement plan.
Avoiding The Fees And Penalties
Of course, there are times when you just don’t have any other option than to make a withdrawal early. There are things you can do to either minimize the penalties or avoid them completely. Here are some of the steps you can take:
1. Check if You’re Qualified for Exception
Sometimes, the government will waive the penalty if your situation is desperate. If you’ve recently lost your job, for example, the IRS may allow an exception. This only works if you’re around 55 years old though. If you work for the federal government, law enforcement, customs, air traffic control, or border protection, you can get an exception at 50. Other exceptions may apply to the following:
- People who recently gave birth or adopted the same year as the cash-out (withdrawal of up to $5,000 per account without the typical 10% penalty).
- The cash out is meant to pay an IRS levy.
- You’ve recently suffered a natural disaster.
- You’re working for the military, both as a reservist and as active personnel.
- You recently became disabled, or are disabled.
- If you rolled the plan over into a different retirement plan within the next 60 days.
- If you’ve over-contributed to the plan and want to take the excess back.
2. Hardship Distribution
You may also be qualified for a hardship distribution and the penalties can be waived when you do an early withdrawal. A hardship distribution is described by the IRS as a heavy and immediate financial need. This may include the following:
- You may be hospitalized and need help with medical bills for you or your family.
- You may need money for getting a house, but not for paying a mortgage.
- Paying your college tuition or fees.
- You need money for board or rent for you or your family.
- You may need money to avoid being evicted.
- Paying for funeral fees.
- If you’re using the cash out to repair your home following a disaster.
3. Convert Your 401k Into An Individual Retirement Account
Another way you might be able to avoid the penalties of withdrawing your 401(k) too early is by converting it into an Individual Retirement Account, or IRA. They have different withdrawal rules from 401(k), but you may need to look into IRA’s before you do.
IRA’s are different in that they don’t have mandatory withholding, depending on the type of plan you have. You will still need to pay taxes when you file your return, but at least you get a bigger check when you cash out. Make sure you transfer the money you get from the 401(k) into your IRA within 60 days, otherwise you will still have to pay the resulting penalties.
4. Minimize Your Cash Out
Sometimes, you might not be able to waive the penalties and fees when you cash out regardless of what you do. That’s why it’s best to withdraw just what you need, and nothing more. The larger the amount you take out, the bigger the fees and penalties. If you can manage just by withdrawing $5,000, and pay $500 in penalties, then stick with that. Don’t withdraw $10,000 “just in case” and end up paying $1,000 in penalties. That’s an extra $500 of your 401k early withdrawal penalties you could simply keep in your account to secure your retirement.