Emergencies happen. If you lose a job, get hit with unexpected medical bills or face other financial hardships, you may be tempted to tap into your 401(k) or IRA for much-needed cash.
Financial advisors will tell you to exhaust all other possibilities before taking money from a retirement account. But if you decide you have no other options, it's important to understand the very strict rules surrounding early withdrawals.
Generally, if you take out money before age 59 1/2, you face a 10 percent penalty and owe regular income taxes on the amount you withdraw. There are some exceptions under which you can avoid a penalty, but you'll still pay taxes.
"The rules for taking distributions from retirement accounts are important to understand because the penalties are harsh for not knowing," says Howard Hook, a certified public accountant with EKS Associates in Princeton and Roseland, N.J. "Also, while the IRS in recent years has allowed taxpayers to correct mistakes made in certain circumstances, the old excuse of pleading ignorance does not work."
The rules surrounding withdrawals from 401(k)s and Individual Retirement Accounts (IRAs) are different. Likewise, Roth IRAs and Roth 401(k)s have their own rules, too.
Here's what you need to know.
About 401(k) Withdrawals
While the IRS allows for certain kinds of hardship withdrawals from workplace 401(k) accounts, employers are not required to offer the option. Check with your benefits administrator about the specifics of your plan.
These withdrawals allow you to take a penalty-free distribution, but you'll still owe taxes on the withdrawal if:
- You're disabled.
- You retired or otherwise left your job at age 55 or older.
- You use the funds to pay unreimbursed medical bills that exceed 7.5 percent of your adjusted gross income.
- The distribution is ordered by a court in the case of divorce. This is called a Qualified Domestic Relations Order.
- Distributions after you leave your job are "Substantially Equal Periodic Payments," or SEPPs. You'd have to take these payments for five years or until age 59 1/2, whichever is longer. The rules and requirements surrounding these kinds of distributions are complex, so make sure you work with a professional financial advisor to avoid any penalties from calculation errors.
There are other circumstances -- if your employer says you qualify -- under which you can take an early withdrawal from a 401(k), but it's no bargain. You'll incur a 10 percent penalty and owe regular income taxes if you withdraw funds to:
- Purchase a primary residence.
- Pay for repairs to certain kinds of damage to your home.
- Pay college tuition, room and board for you or your dependents.
- Stop an eviction or foreclosure.
- Get help in the case of severe financial hardship.
About IRA Withdrawals
There are some circumstances under which you can withdraw funds penalty-free from an IRA before age 59 1/2. These rules apply to both traditional IRAs and Roth IRAs You'll still have to pay taxes on a withdrawal, but you'll avoid the 10 percent penalty if:
- You are permanently or totally disabled.
- You use the funds to pay unreimbursed medical bills that exceed 7.5 percent of your adjusted gross income.
- You are unemployed and you use the withdrawal to pay health insurance premiums.
- You pay an IRS levy on your qualified plan.
- You use the funds for a down payment on a home with a maximum withdrawal of $10,000, or $20,000 if you're married and filing jointly. (You must not have owned a home for the past two years.)
- You pay for higher education expenses for yourself or a dependent. Like 401(k) plans, you can annuitize your IRA by taking SEPP payments.
About The Roth Extra
You have an added penalty-free withdrawal opportunity if you have a Roth IRA or a Roth 401(k) -- and if your employer's plan permits. Contributions to a Roth IRA can be taken out at any time, and earnings may be withdrawn penalty- and tax-free after five years.
About Borrowing From Your Account
You're not permitted to take a loan from your IRA, but some employers allow 401(k) loans under certain circumstances.
Each plan may have its own rules, but generally employees can borrow up to half of their vested account to a maximum of $50,000. With the exception of loans used for home purchases (which have longer repayment), most loans must be paid back over five years.
The loan payments, with interest, are usually taken directly from an employee's paycheck and redeposited into the 401(k) account.
While a 401(k) loan may seem more attractive than an outright withdrawal, they're not without dangers. If you leave your job, the loan must be paid in full within 60 days. If not, the loan would be considered a withdrawal, and you'd owe a 10 percent penalty, plus taxes.
One more (cautious) note on IRAs: While loans are not permitted, you can withdraw funds for up to 60 days without taxes and penalties. This provision is generally used if you're transferring your account from one custodian to another, so the IRS considers it a qualified rollover. As long as the money goes back into your account within the 60-day time frame, you're free and clear. If you don't put the entire amount back, the withdrawal is considered a distribution, and you will owe penalties and taxes.
If you go this route, use great care.
"A short-term loan taken from a retirement account to pay some bills until your bonus check arrives -- except, of course, the check never comes -- becomes very costly," Hook says. "Besides the taxes and penalty, there is the unspoken loss of future tax deferral on that money."
Read more about retirement savings: SecondAct's Take Charge Financial Guide
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