An Early Withdrawal From Your 401(k): Understanding the Consequences
Cashing out a 401(k) early can be tempting, but it can come at a cost. When you cash out your 401(k) early, there are penalties unless you qualify for one of the early withdrawal exemptions. If you're considering cashing out a 401(k) early, learn more about how it impacts your taxes and whether it's the right decision for you.
Key Takeaways
- Most 401(k) plans allow participants to borrow money from the plan. They can repay the loan through automatic payroll deductions. However, these payments will reduce your take-home pay.
- 401(k) loans don't create taxable income. So, you won't pay taxes on the amount you borrow.
- The interest you pay on a 401(k) loan is added to your own retirement account balance.
- An early withdrawal from a 401(k) plan typically counts as taxable income. You’ll also have to pay a 10% penalty on the amount withdrawn if you're under the age of 59½.
Tapping your 401(k) early
If you need money but want to avoid high-interest credit cards or loans, you can make an early withdrawal from your 401(k). But, this option often has tax consequences.
If you understand the impact of an early withdrawal on your finances, you might want to continue. If so, there are two ways to go about it—cashing out or taking a loan. But how do you know which is right for you? And what are the tax consequences you should be expecting?
A 401(k) loan or an early withdrawal?
Retirement accounts, such as 401(k) plans, help people save for retirement. The tax code rewards saving. It does this by offering tax benefits for contributions. It usually penalizes those who withdraw money before age 59½.
If you really need the money, you can often access it with a loan or an early 401(k) withdrawal. But, be mindful of the tax implications.
What is a 401(k) loan?
Most 401(k) plans allow participants to borrow their own money from the plan. They can repay the loan through automatic payroll deductions.
Unlike personal loans and home equity loans, 401(k) loans are usually easy to get. There's no credit check, and applications are typically short. However, they're like other types of debt in that you must pay interest on the amount you borrow. The plan's administrator sets the interest rate. But, it must be like the rate from a bank. The good news, though, is that you are paying interest to your own 401(k) account, rather than to an institution.
Typically, 401(k) loans must be repaid within five years. That repayment period can be extended if you use the loan to purchase a home.
TurboTax Tip:
Exceptions to the early withdrawal penalty include total and permanent disability, unreimbursed medical expenses, and separation from service at age 55 or older from the employer plan at the job you are leaving.
What is a 401(k) early withdrawal?
Generally, anyone can make an early withdrawal from 401(k) plans at any time and for any reason. However, these distributions typically count as taxable income. If you're under the age of 59½, you typically have to pay a 10% penalty on the amount withdrawn. The IRS does allow some exceptions to the penalty, including:
- total and permanent disability
- unreimbursed medical expenses (greater than 7.5% of adjusted gross income)
- employee separation from service at age 55 or older (age 50 for most public safety employees) but only from the plan at the job you are leaving
Some 401(k) plans allow hardship distributions. You can take them while still in the plan. Each plan sets its own criteria for hardships. But they usually include things like:
- medical or funeral expenses
- avoiding eviction or foreclosure
- the cost of repairing damage to the employee's home
Hardship withdrawals usually don't qualify for an exception to the 10% penalty. This is true unless the employee is age 59½ or older or qualifies for one of the exceptions listed above.
Starting in 2024, the Secure 2.0 Act added cases where money can be withdrawn. These cases include:
- financial emergencies - one withdrawal per year up to $1,000
- victims of domestic abuse - within the past 12 months can withdraw up to the lesser of $10,000 or 50% of their account
- federally declared natural disaster areas - withdraw up to $22,000
- terminal illness allows withdrawal. You can take any amount if diagnosed with an illness that will likely cause death within seven years.
Which is right for you?
For many, 401(k) loans are a better option than early withdrawals. When you pay the money back in time, you won't have to pay taxes on the amount withdrawn. Plus, the interest you'll pay is added to your own retirement account balance.
However, there are several reasons to think twice before taking out a 401(k) loan.
- Decreased paycheck. Most 401(k) plans require participants to repay their loan through payroll deductions. When you borrow from your 401(k), your monthly take-home pay will be reduced by the loan amount. If you're already having money problems, a pay cut could make them worse.
- Missed retirement contributions and employer matching. Some plans don't allow participants to contribute to a 401(k) while they have a loan. If it takes you five years to repay your loan, that could mean five years without saving for retirement. Also, if your employer matches your contributions, you'll miss out on their contributions too.
- Missed investment returns. While your money is loaned out, it's not invested in the market. You could potentially earn a better rate of return if it was invested in your 401(k) plan.
- Fees. Many plans charge origination fees and/or quarterly maintenance fees on loans. This can drastically increase the cost of borrowing money from your 401(k).
- Potential tax consequences. If you leave your job while you have a 401(k) loan outstanding, you have a limited amount of time to repay the loan. You have until the tax return due date to repay the loan or roll it over.
For example, if you left your job in December of 2024 with a $2,000 balance on your loan, you would have until April 15, 2025, to repay $2,000. You could also get an extension for your tax return.
- If you're not able to repay the loan, your employer will treat the unpaid balance as a distribution.
- Typically, it is taxable. It is also subject to a 10% early withdrawal penalty.
Ideally, you want to leave your 401(k) alone until retirement. However, if you find yourself in a tough spot, borrowing from your 401(k) might be better than just cashing out. Just make sure you understand the risks. Do what you can to repay the balance fast. Then, you can start rebuilding your retirement savings.
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