Chapter 16
Withdrawing Money Before You Retire
IN THIS CHAPTER
Withdrawing from your IRA
Tapping into your 401(k)
Using 401(k) money for non-retirement reasons
Giving yourself a loan
Life is so unpredictable. Just when you think you have everything under control … wham! An unexpected expense jumps out of a dark alley, bops you on the head, and runs off with your wallet. At times like that, it’s nice to know that you may be able to tap your retirement funds to tide you over.
Uncle Sam permits two ways for getting money out of your 401(k) while you’re still working — hardship withdrawals and loans. However, your employer isn’t required to allow you to do either one. Before you go any further with this chapter, check your summary plan description (summary of your plan’s rules) to see what your plan allows. It may permit both loans and hardship withdrawals, only one or the other, or neither. Many plans don’t permit loans because administering them can be a hassle. You’re probably wondering why you can’t get your money any time you want. After all, it’s your money, right? Yes, it is, but remember that Uncle Sam gives you big tax breaks to help you save in a 401(k). He really wants you to use this money when you retire, so he makes it difficult to take it out earlier.
If you are allowed to take a loan or make a hardship withdrawal, you’ll be much better off if you understand the rules and how much you may have to pay in taxes and penalties, before doing so. You may decide that it’s better for your long-term future to look for another source of emergency funds first.
IRAs don’t restrict when you take money out so you can do that at any time without having to ask for approval; however, a tax penalty may be imposed.
The rules I discuss in this chapter apply if you’re still working for the employer that sponsors your 401(k) plan. The rules are different for taking money out after you leave your employer. I discuss those details in Chapter 17. That chapter also covers withdrawals from your IRA to provide retirement income.
Taking Money from Your IRA
You can withdraw money out of a traditional IRA without a tax penalty if you’re over age 59½. You also pay no tax penalty for a number of other purposes or in specific situations:
- To purchase a first home (you’re limited to $10,000 over your lifetime)
- To pay qualified higher education expenses for you, your spouse, or relatives such as the children or grandchildren of you or your spouse
- You experience total and permanent disability
- To pay an IRS levy
- To pay health insurance premiums while you’re unemployed
- Certain distributions to qualified military reservists called to active duty
- To pay expenses related to the birth or adoption of a child
These exceptions enable you to utilize your IRA for reasons other than retirement, making an IRA account even more valuable. Easier access to the money in your IRA than in a 401(k) is a big reason to consider transferring your 401(k) into an IRA when you change jobs.
At your death, your beneficiaries can withdraw the money without penalties, but it’s too nice a day to think of that, right?
This is a more extensive list than what you can do with money in a 401(k) plan.
Accessing Your 401(k) Plan Money While Working
It can be difficult, if not downright impossible, to make a withdrawal from your 401(k) while you’re working for the company that sponsors the plan.
The tax breaks you get with a 401(k) plan come with a price. It can be very costly to take your money out of the plan before you retire — if you can even do it at all. Many employers permit you to borrow money from your 401(k), but not necessarily for any old reason. Most plans permit hardship withdrawals, which are withdrawals from your account to pay expenses when you’re in financial difficulty. Your employer may permit withdrawals only for reasons approved by the IRS.
People often think that they’re automatically allowed to withdraw money from a 401(k) for higher education expenses or for buying a home, and that they won’t owe an early withdrawal penalty on the amount. This is false. Your plan may allow you to make a withdrawal for these reasons, but it doesn’t have to.
When you leave your employer, either to retire or to change jobs, you generally have a window of opportunity to get your money. In most cases, you can receive payment of your account or transfer the money into an IRA or another employer’s retirement plan (see Chapter 10). I highly recommend transferring the money to another plan or IRA, or leaving the money in the plan to avoid a high tax bill.
Don’t wait for an emergency to check on the rules for accessing your money. You may find that you can’t make a withdrawal or that you will lose about half the value in taxes and penalties if you do make a withdrawal.
Federal law allows three ways to get money out of your 401(k) while you’re working for the employer sponsoring the plan. But keep in mind that your employer isn’t required to allow these features, so they may not be available in your plan. The three ways to obtain money from your 401(k) are as follows:
- Unrestricted access to plan assets after you reach age 59½: The amount withdrawn becomes part of your taxable income for that year.
- Withdrawals for financial hardships as defined by law and IRS regulations: Hardship withdrawals, as they’re known, are fully taxable and are usually also subject to an additional 10 percent federal early withdrawal penalty (and possibly additional state and local taxes, as well).
- Plan loans: These are subject to numerous restrictions. You may get a plan loan to pay for excessive medical expenses, but you won’t get one to buy a yacht.
The first two options listed are known as in-service withdrawals, because you make them while you’re “in the service of” your employer.
Strangely enough, federal law makes it theoretically easier to withdraw your employer’s contributions than your own pre-tax deferrals while you’re working. Your employer may allow you to take the employer contributions out for any reason. But most employers place restrictions on withdrawals of their contributions because they want you to use the money for retirement, so you won’t be able to use those to buy your yacht.
Loans and in-service withdrawals are a mixed blessing because, while they give you some flexibility with your money, they’ll likely reduce the ultimate value of your retirement nest egg. But being able to withdraw these savings can be an important plan feature if you think that you may need your money before reaching age 59½. This is particularly true for younger employees who have a long way to go until retirement.
Facing Hardship with Your 401(k) at Your Side
Most 401(k) plans allow hardship withdrawals, but not all of them do. Why wouldn’t a plan let you withdraw money to pay for an emergency? Your employer may want you to use the money only for retirement — period. In the following sections I assume that your 401(k) plan offers a hardship withdrawal possibility.
Defining a hardship
You can’t take a hardship withdrawal if your yacht breaks down and you need to buy another one before the spring thaw. Hardship withdrawals are limited to specific situations and are permitted only if you have an immediate and heavy financial need that can’t be satisfied from other resources.
Certain expenses are deemed to be immediate and heavy, including
- Costs related to the purchase of your primary residence
- Tuition and related educational expenses for the next 12 months for you, your spouse, a dependent, or a nondependent beneficiary
- Medical expenses for you, your spouse, dependents, or a primary beneficiary not covered by insurance
- Payments necessary to prevent either eviction from your principal residence or foreclosure on the mortgage for your residence
- Burial and funeral expenses for you, your spouse, dependents, or a primary beneficiary
- Certain expenses for the repair of damage to your primary residence such as fire, flood, hurricane, or earthquake that qualify for the casualty deduction under IRC Section 165
A distribution isn’t considered necessary to satisfy an immediate and heavy financial need if you have other resources available to meet the need, including your spouse’s and minor children’s assets. You must also have obtained all other currently available distributions from the 401(k) plan and all other employer plans maintained by your employer.
Your employer has the option to require you to take a plan loan rather than a hardship withdrawal.
You can also withdraw Roth contributions to a 401(k). Any investment gains withdrawn are taxable, and the 10 percent penalty tax applies if you haven’t made contributions for at least five years, and you haven’t reached 59½. The penalty tax doesn’t apply for distributions due to death or total and permanent disability. Any Roth contribution withdrawal must include a pro-rata portion of any investment gains.
All withdrawals of non-Roth contributions prior to age 59½ are taxable including the 10 percent early distribution penalty except in the following circumstances:
- You’re a highly compensated employee required to take a distribution to make the plan comply with a nondiscrimination test.
- Your death.
- To pay a qualified domestic relations order (QDRO), issued as part of a divorce decree.
- To pay an IRS levy of your account.
- A series of substantially equal periodic payments (SEPP), which I explain in Chapter 17.
- To pay medical expenses in excess of 10 percent of your adjusted gross income.
- You withdraw money within 30 to 90 days of your first automatic enrollment contribution deduction. You forfeit any matching employer contributions if you do this.
- To add a child to the family. The Secure Act passed by Congress in December 2019 permits each parent who has an IRA or 401(k) account to withdraw $5,000 for the birth or adoption of a child.
- To make certain payments to a reservist called to active duty.
You are totally and permanently disabled.
The IRS definition of total and permanent disability requires you to be “unable to perform substantial gainful activity” because of an identifiable physical or mental impairment that is expected to be of “long-continued and indefinite duration.” Your doctor needs to confirm that you are unable to work due to a physical or mental disability and that you will continue to be unable to work permanently or at least for a very long period of time. You must submit IRS Form 5329 when you submit your tax return to claim the exemption. Enter Code 03 for disability where it asks for the code for the exemption. Also look at Box 7 of the 1099-R you received for the distribution to be sure that the distribution code used is 03. If not, contact your former employer or service provider to get a corrected form.
Participants who are unhappy with their 401(k) investments frequently ask whether they can take their money out of the plan as a hardship withdrawal, while they’re working, and roll it into an IRA. The answer is no. You can only transfer your money to an IRA under the conditions explained in Chapter 10.
If you manage to withdraw your money using a hardship withdrawal before you turn 59½, you’ll be heavily taxed. Not only will you owe federal and perhaps state and local income tax on the amount withdrawn, but you’ll also owe a 10 percent federal early withdrawal penalty on the entire amount unless the withdrawal is for one of the reasons that qualify for an exemption. If you take a hardship distribution, the money you withdraw is no longer eligible for a rollover.
Taking out a loan lets you avoid these penalties; however, other costs are involved. I explain these costs in “Both a Borrower and a Lender Be” later in this chapter.
Determining the amount
You can withdraw only the amount you need to meet your hardship expense. Because you have to pay tax on a hardship withdrawal, you can include the taxes you’ll owe. The next section, “Calculating the tax you owe,” provides an example.
The money you’re allowed to withdraw for a hardship may be limited to the money you’ve contributed (excluding investment gains), or it may include vested employer contributions and money you have rolled into the plan from an IRA or another retirement plan. Your employer decides the rules. Many employers don’t permit their contributions to be withdrawn for a hardship because they want this money to stay in the plan and be used to provide retirement benefits.
If your plan lets you borrow money from your 401(k), you may be required to take a loan before taking a hardship withdrawal. It depends on your plan’s rules. In this case, you take the maximum loan allowed to you, and then if you still need money, you take the rest of what you need as a hardship withdrawal. I discuss loans in more detail in the section “Both a Borrower and a Lender Be” later in this chapter.
Calculating the tax you owe
You need to pay federal income tax, and state income tax if applicable, on the amount of your hardship withdrawal. (You didn’t think you’d be able to avoid taxes, now, did you?) Additionally, if you’re under 59½ years old, you have to pay a 10 percent early withdrawal penalty on the amount you take out unless it is for one of the reasons mentioned in the preceding “Defining a hardship” section. Some states also impose an early withdrawal penalty of a few percentage points. In total, you’ll probably have to pay 25 to 40 percent of the amount withdrawn, and you may have to pay even more.
For example, say you need $10,000 for a down payment on a house, your federal tax rate is 22 percent, and you’re under 59½. Because of your age, you’ll owe a 10 percent early withdrawal penalty along with taxes, for a total of 32 percent. Without taking into account state and local taxes, you’ll need to withdraw $14,706 in order to have $10,000 for your down payment and $4,706 to pay 32 percent in taxes. (To get this amount I subtracted 32 percent from 100 percent leaving 68 percent, which is 0.68. I then divided $10,000 by 0.68, which equals $14,706.)
Don’t spend all the money you withdraw without first determining how much you owe in taxes! Your employer normally withholds 20 percent of the hardship withdrawal. However, this mandatory tax withholding has no relationship to the amount of federal and state tax you’ll owe — it’s simply a deposit to the IRS. You’ll determine the actual taxes owed when you figure your taxes for the year you receive the distribution, and you’ll have to pay the difference. Determine how much tax you’ll have to pay — and pay it — before you do anything else. Many participants fail to do this and end up with an unexpected, whopping tax bill.
Participants often ask me whether withdrawing money to buy a home or to pay for college expenses exempts them from the 10 percent early withdrawal penalty. The answer is no. The confusion arises because you can avoid this penalty if you withdraw money from an IRA to buy a home or pay for higher education expenses. I discuss rules for IRAs in Chapter 8.
Another consequence of hardship withdrawals is that you disrupt your retirement savings. Say you withdraw $14,706 in order to end up with $10,000 after paying taxes (as in the earlier example). You don’t just lose the $14,706 from your 401(k); you lose what this money would’ve been worth by the time you retire. If that money had stayed invested for 30 years with a 9 percent return, it would be worth $195,115. You’ll have to substantially increase your contributions to make up this loss by the time you retire.
Dipping into Your 401(k) Money to Buy Your First Home
The tax bite and disruption to your retirement account are two good reasons to avoid a hardship withdrawal, unless, of course, the withdrawal is absolutely necessary. But withdrawing money to buy your first home may be a smart financial decision.
Investing in a home can bring you a good return. Assume that you take a hardship withdrawal of $25,000 at age 35 to buy a $250,000 home with a 30-year mortgage. Assume that the value of your home appreciates at a rate of 3 percent per year. After 30 years, your house would be worth $604,000. Of that, $354,000 is capital appreciation ($604,000 − $250,000).
If the $25,000 had stayed in your 401(k) plan and earned a 9 percent return until you turned 65, it would’ve grown to $331,667, which is less than the capital appreciation on your house. This is a simplified example to show you the potential value of home ownership.
If you’re using some of your 401(k) money to purchase your first home, take a smart approach that either eliminates or substantially reduces your tax bite: Essentially, you need to buy your home as close to the beginning of the year as possible.
Assume the following:
- Your first home costs $250,000.
- You have to withdraw $25,000 to help cover the initial costs.
- The property taxes are $3,500 per year.
- The mortgage will be $225,000 at a 3.5 percent interest rate.
- The settlement date is January 15.
In the year you buy the home, the property taxes you pay will be $3,353, and the mortgage interest will be $7,575, because you will have owned the home for only 11½ months. You start to receive the tax benefits of first-time home ownership by deducting the interest and taxes — $10,928 of deductions that will offset some of the impact of having to add the $25,000 withdrawal from your 401(k) to your total income.
But this strategy only works if you withdraw the $25,000 during the same year that you buy the home. You get less of a benefit the later in the year that you buy the home, because you have to include the full withdrawal in your income. But you can deduct interest and tax payments only for the period that you own the home. The worst case is to buy your home in December because you get the tax break related to home ownership only for part of one month. In this case, you’d have a $25,000 taxable distribution minus a $910 tax break, meaning that $24,090 is taxable income.
You may have to borrow the money, rather than withdraw it, if your plan gives you both options. Again, this is one of those crazy government things.
Both a Borrower and a Lender Be
Most 401(k) plans allow loans, but your plan may limit your ability to borrow from your 401(k). Your employer may not want you to squander your retirement money on something that’s not really a necessity.
The following sections lay out general rules for loans. Keep in mind that the rules for your specific plan may differ.
Giving one good reason …
You can take out a loan only if your 401(k) plan document allows you to borrow for the specific reason that you have in mind. Some plans permit borrowing for any reason, but another common approach is to permit loans only for the reasons included on the hardship withdrawal list earlier in this chapter in the section, “Defining a hardship.” You can get specific details about account loans from your summary plan description or from your benefits office or 401(k) plan provider.
Figuring out how much you can borrow
The government sets the limits on how much you can borrow. Generally, you’re allowed to borrow no more than 50 percent of your account value up to $50,000 maximum. The other half stays in the account as collateral. However (there always seems to be a “however”), government rules permit borrowing 100 percent of an account up to $10,000. For example, if your account value is $15,000, you may be able to borrow $10,000, even though 50 percent of $15,000 is only $7,500. Some plans don’t allow this, though — they limit all loans to 50 percent of the account value for the sake of simplicity. Some plans also impose a minimum loan amount because it’s not worth the hassle for them to administer a loan for only a few bucks.
Determining how much interest you pay
The interest that you pay on your 401(k) loan is determined by your employer and must be at a level that meets IRS requirements. It’s usually the prime rate (the interest rate that banks charge the most creditworthy companies) plus 1 or 2 percentage points. In most plans, the interest that you pay goes back into your account, so you’re in the interesting position of being both the borrower and the lender (what would Shakespeare have said about that?).
Paying the piper: Repayment rules
You normally have to repay the loan within five years, but you can repay it faster if your plan permits. Also, your employer may permit a longer repayment period if the money is used for a home purchase.
Employers usually require you to repay a loan through deductions from your paycheck. The loan repayments are taken out of your paycheck after taxes, not pre-tax like your original contributions. Then, when you eventually withdraw this money in retirement, you pay tax on it again. I repeat: You pay tax twice on money used to repay a 401(k) loan.
The fact that most employers require you to pay back the loan with payroll deductions means that if you’re laid off or you quit your job, it becomes impossible to keep repaying the loan. What happens then? You have two choices: Either repay the entire outstanding loan balance right away or take the amount as a taxable distribution (payment from the account).
If you don’t have the money to repay the loan, you must declare the entire unpaid loan balance as income on your tax return. Adding insult to injury, if you’re younger than 55 when you leave your job, you’ll probably have to pay an early withdrawal penalty of 10 percent. As I explain in the earlier section, “Calculating the tax you owe,” this withdrawal penalty hurts. Also check out Chapter 17 for information on an exception to the rule known as 72(t) withdrawals.
If you take a loan, you should be pretty sure that you’re going to stay with your employer long enough to repay it. At the very least, try to have a Plan B in the works (other than robbing the nearest bank) to help you scrape together enough money to repay it in full if you’re laid off.
To Loan or Not to Loan (To Yourself, That Is)
Although the ability to take a loan is nice in an emergency, don’t use the privilege lightly. Taking a loan from your 401(k) rather than from another source has definite disadvantages.
The most attractive feature of a loan is that it isn’t taxable when you receive the money.
However, you eventually have to pay tax on the loan. You have to repay the loan and interest with after-tax deductions from your paycheck, so you simply pay tax on the loan every pay period rather than all at once. And when you withdraw money at retirement (including those repayments that were already taxed), you pay income tax again. You’re taxed twice on the amount of a loan.
If you can’t afford to continue making pre-tax contributions to the 401(k) at the same time that you’re repaying the loan, your eventual account balance will be lower than if you hadn’t taken the loan. It will be worth much less if you can’t afford to pay the loan and to contribute the amount needed to get the maximum employer matching contribution.
Say you’re contributing $1,800 a year pre-tax to your 401(k), and you receive an employer matching contribution of $900. If you stop contributing for five years, you lose out on $9,000 of your own contributions ($1,800 × 5) and also on $4,500 in employer matching contributions ($900 × 5). If those amounts are invested in the 401(k) plan over 30 years, with an average return of 9 percent, they will grow to $139,340.
If you take a loan, try to continue making pre-tax contributions to your 401(k) while you’re repaying the loan. Doing so will help build up your 401(k) balance over the long run.
Weighing a Hardship Withdrawal versus a Loan
You may come up against a situation where you’re required to tap into your 401(k), either by using a hardship withdrawal or a loan, because you have no alternative.
Table 16-1 compares the end result of a loan and a hardship withdrawal on the balance of a hypothetical account after five years. In this case, the person repaying the loan isn’t making new contributions to the account. The interest rate for the loan is 4 percent.
TABLE 16-1 Impact of Loan versus Hardship Withdrawal on Account Balance
Loan | Hardship Withdrawal | |
|---|---|---|
Beginning account balance | $20,000 | $20,000 |
Amount borrowed or withdrawn | $10,000 (borrowed) | $14,706 (withdrawn to have $10,000 left after tax) |
Monthly repayment (loan) or contribution (hardship withdrawal) | $202.76 monthly loan repayment for 60 months | $259.95* monthly contributions for 60 months |
Annual investment return | 9 percent | 9 percent |
Balance after five years without employer contribution | $28,545 | $24,406 |
Balance after five years with employer contribution of 50 cents on the dollar | $28,545 | $32,780 |
*Calculating $259.95 times 22 percent (your tax rate) equals $57.19 of tax savings ($259.95 minus $57.19 equals $202.76) — the same amount as the monthly loan repayment.
You can see that the decision regarding whether to take a loan or hardship withdrawal isn’t cut-and-dried. If your employer makes a matching contribution, the hardship withdrawal may work out better for you in the long run, if you can’t afford to pay the loan and continue making new contributions. However, if you can afford to keep making pre-tax contributions to your account while paying back a loan, the loan may be a better long-term solution. A loan may also work out better if your employer doesn’t make matching contributions.
You can withdraw up to 100 percent of your vested account balance for a hardship withdrawal but no more than the amount necessary to meet the financial need. You can borrow 100 percent of the first $10,000 or 50 percent of your vested account balance when it exceeds $20,000. If your account balance is between $10,000 and $20,000, you may borrow $10,000. You can borrow $15,000 if your account balance is $30,000. The maximum amount you may borrow is $50,000. Remember that your plan doesn’t have to allow you to make hardship withdrawals and loans and that you’ll owe taxes on hardship withdrawals.
Saying No to Yourself
The bottom line is that both loans and hardship withdrawals are much less attractive than they first appear for most purposes. As a result, you should use them only when absolutely necessary rather than as a convenience.
By taking a loan or hardship withdrawal, you’re most likely reducing the eventual balance of your retirement account. It may make sense to take money out of your 401(k) to buy a first home because a home generally gives you a good return on your investment. Likewise, borrowing from your 401(k) to start a business may be a smart move if the business does well — but not if it flops.
People also often ask whether to take money out of a 401(k) to pay off credit card debts charging high interest rates. The thinking is that it’s better to pay 4 percent interest to yourself (with a 401(k) loan) than 22 percent interest to a credit card company. This may be true, but the danger is that you’ll simply rack up more debt, and you’ll have no 401(k) to bail you out. If you use 401(k) money to pay off credit card debt, make sure that you cut up your credit cards or that you always pay the full balance each month so that you don’t dig yourself back into the same hole.