Your retirement savings are meant to help you live comfortably during your golden years. But if you need quick cash, you may be tempted to make an early 401(k) withdrawal before then.
Doing so has consequences. You’ll likely incur an early withdrawal penalty, so it’s also important to consider alternatives before you put your financial future in jeopardy.
What is a 401(k) early withdrawal?
A 401(k) early withdrawal occurs when you pull money from your workplace 401(k) retirement account before you hit age 59 1/2. In most cases, early withdrawals come with income taxes and a penalty.
Implications of withdrawing from your 401(k) early
Because money invested via 401(k)s is tax-deferred, your distributions will count as taxable income. But if you’re under age 59 1/2, you’ll also have to pay a 10% tax penalty on the early withdrawal (with some exceptions).
Another big downside to pulling money from your 401(k) early is that it will miss out on the long-term returns that investing in financial markets can provide. The annualized total return of the S&P 500 stock market index between 1928 and 2022, for example, was nearly 10%.
How to calculate the penalty for early 401(k) withdrawals
The 401(k) early withdrawal penalty is typically 10% of the amount of your distribution, so you can calculate your tax penalty by multiplying the amount you’re planning to withdraw by 0.1.
Say you’re planning to withdraw $10,000 from your 401(k) early. Your penalty would be $1,000 ($10,000 times 0.1 equals $1,000).
Early 401(k) withdrawal process
The rules around early withdrawals will vary depending on the 401(k) plan, so you’ll want to reach out to your HR department to determine what you’re allowed to do and whether or not you qualify for an exemption from the penalty.
Once you determine that you’re going to pull money from your 401(k), you’ll be required to fill out certain paperwork from your employer. If you’re younger than 59 1/2, you’ll also have to calculate how much money you will need to take out for taxes and penalties.
401(k) early withdrawal exceptions
The Internal Revenue Service (IRS) allows some penalty-free early 401(k) withdrawals, including those for unreimbursed medical expenses up to 7.5% of your adjusted gross income (AGI), disability, terminal illness and if you lose or leave your job when you’re age 55 or older.
You may also be able to get an exception to the 10% tax penalty via substantially equal periodic payments (SEPPs). These regular payments are made over the course of five years or until you turn 59 1/2 — whichever comes later. There are qualifications and rules, like the fact that you can’t make withdrawals from a fund managed by your current employer, so make sure to check the IRS requirements before opting for SEPPs.
The SECURE 2.0 Act, which passed in late 2022, expanded the list of situations in which you can avoid the 10% early withdrawal penalty, including for certain federally declared disasters and domestic abuse. Starting in 2024, you can also take out an early, penalty-free, “emergency” distribution up to $1,000 per year for certain unforeseeable financial needs. You can’t take another one for three years unless you repay the first.
Impact of 401(k) early withdrawal on retirement savings
The impacts of an early withdrawal can be “very detrimental” to retirement savings, said JJ Feldman, co-head of wealth management at Helium Advisors, a registered investment advisor.
The most important impact of an early withdrawal is the loss of tax-deferred compounding on that withdrawn money — a powerful tool you cannot get back later, Feldman said.
Plus, pulling your money from the market likely means missing out on solid returns: Sitting out of the S&P 500’s 10 best days between January 2003 and December 2022 cuts its annualized return to 5.6% from 9.8%, according to J.P. Morgan Asset Management.
Alternatives to 401(k) early withdrawal
Instead of removing money from your 401(k), you can consider taking out a 401(k) loan. You’ll want to check how much your specific employer’s plan will let you take out in the form of a loan, but the IRS allows you to borrow as much as 50% of your savings, up to $50,000, within a year. (There is an exception if 50% of your savings are less than $10,000, in which case you can borrow up to $10,000 if your plan allows it.)
With a 401(k) loan, you won’t have to pay taxes or penalties like you would with an early withdrawal, and the interest you pay will go back in your retirement account. However, if you leave your job that offers the 401(k), you might have to pay the loan back in full. If you don’t, that money could be taken out of the account, which could also be subjected to the early 10% distribution policy.
A 401(k) loan doesn’t require a credit check, so no need to worry about the debt impacting your credit score.
Another option is a hardship withdrawal. Some plans allow for withdrawals needed due to an “immediate and heavy” financial need. Qualified needs — which include preventing eviction or foreclosure, or covering certain medical expenses and tuition, among others — are outlined by the IRS but can vary from one employer plan to the next. Your withdrawal can’t exceed the cost of covering the need, and you might have to prove that you’ve exhausted all your other options. Hardship withdrawals are subject to income taxes and may be subject to the 10% penalty that early withdrawals face, so check with your HR department before starting the process.
If you don’t have emergency savings, other alternatives to tapping your 401(k) can include withdrawing from an individual retirement account (IRA) or taxable brokerage account, taking a personal loan or a home equity line of credit, or using a credit card with a 0% introductory annual percentage rate or balance transfer. If you need to make the withdrawal for a medical expense, you can also consider tapping a health savings account if you have one. However, making any of these moves should come with careful considerations, as each one has its downsides.
401(k) early withdrawal versus a loan: Which is better?
While you’ll want to exhaust other options before touching your retirement savings, you may find yourself in a position where you have to choose between borrowing from your 401(k) or taking an early withdrawal.
When you take a loan from your 401(k), you must pay it back with interest — but that payment goes back into your account and, thus, towards your retirement, and you don’t have to pay penalties and taxes when you borrow the money. With a 401(k) early withdrawal, you’ll have to pay taxes and likely penalties, and you cannot return the money to your account later.
Everyone’s financial situation is different, but Fidelity Investments illustrates that the impact of taking $15,000 from a $38,000 account balance results in $0 in taxes and penalties for a loan and $8,810 in taxes and penalties for an early withdrawal.
“We rarely, if ever, recommend an early withdrawal,” Feldman said. “An early withdrawal should only be used in the case of emergencies.”
Frequently asked questions (FAQs)
The typical penalty for an early 401(k) withdrawal is a 10% tax on top of the regular income taxes due on the amount withdrawn.
An early withdrawal counts as taxable income. You’ll likely also have to pay the 10% 401(k) early withdrawal penalty.
Employers’ rules around early withdrawals vary, and your employer can refuse your request if it goes against their plan rules.
