401(k) withdrawal rules

Contributing to a 401(k) consistently is generally considered a strategic way to save for retirement. 401(k) plans are tax-deferred investment savings accounts designed to help employees maximize their retirement savings through several tax advantages. The money in your 401(k) is generally meant to stay untouched until you retire. 

However, if you choose to withdraw money from your 401(k) or individual retirement account (IRA) account before age 59 1/2, you may be subject to a 10% early withdrawal penalty. 

We’ll introduce you to the general rules of 401(k) withdrawals and what can happen if you decide to take out money from your account. We’ll also expand on a few options for individuals considering a 401(k) withdrawal and detail exceptions to when you can withdraw money from your retirement account without a tax penalty. 

What are the different types of 401(k) withdrawals? 

While there are several reasons you may need to withdraw money from your 401(k) account, there are generally four types of withdrawals:

1. In-service withdrawals

2. Hardship withdrawals

3. Required minimum distributions

4. Termination distributions

Let's review these withdrawal types and their corresponding rules below. 

1. In-service withdrawals

An in-service distribution happens while a participant is still employed at the company. Plans aren't required to allow in-service distributions. If a plan allows any in-service distributions, they'll be listed in the Adoption Agreement. To take an in-service distribution, you must meet the requirements listed in the plan document, which is usually an age and/or service requirement.

Plans may limit in-service withdrawals to certain sources or restrict sources available for withdrawal to those that are 100% vested only. In addition, ERISA regulations restrict the in-service distribution of employee deferral sources to hardship withdrawals if under the age of 59 ½. Many plans permit participants to take an in-service distribution at the age of 59 ½ because of the age restrictions on deferrals and the avoidance of the 10% early withdrawal penalty.

If you’re withdrawing from your retirement account, you must still pay taxes on your 401(k) withdrawal because it's considered taxable income. However, if you withdraw available Roth funds, you won't have to pay taxes on your original contributions because the money you contributed to the account has already been taxed. Earnings may be tax-free as well if you meet certain requirements.

Most plans will also allow you to take any rollover source as a distribution (that is, money previously rolled into the plan from another qualified plan or IRA) at any time, although this is subject to taxation and early withdrawal penalties if under age 59 1/2. 

2. Hardship withdrawals

Hardship withdrawals are a specific type of in-service withdrawal that can be taken only if you've experienced a specified event and can provide the required documentation as evidence of your financial need. You'll only be eligible for a hardship distribution if you're experiencing an immediate and heavy financial need that cannot be relieved by other resources (including in-service distributions as stated above).  

Reasons that may qualify as a hardship withdrawal include:

• Medical expenses

• Prevent eviction or foreclosure on your principal residence

• Funeral expenses

• Purchase of a principal residence

• Tuition costs for you or your dependents

• Repairs needed to fix your home related to a casualty loss

• Expenses related to a federal disaster declaration

Note that every plan is different. What your 401(k) plan administrator determines as a hardship may not be the same as a different plan. Your plan may also require you to submit documentation of hardship circumstances. 

Like most withdrawals, hardship withdrawals may be subject to income tax and an early withdrawal penalty if you are under age 59 ½. You will also be limited to withdrawing only what you need to cover your immediate expenses, plus taxes.  

Required minimum distributions

Required minimum distributions (RMDs) are lump-sum withdrawals that you must take out of your retirement account once you reach a certain age. SECURE Act 2.0 raised the minimum age for RMDs to 73 (up from 72) to help some Americans gain more interest on their retirement savings and delay income taxes. 

You may have the option to withdraw more than the required amount. Starting in 2024, Roth 401(k) and 403(b) accounts are excluded from RMD calculations and distributions. Your RMD is determined by the total account value of your retirement account on December 31 of the prior year divided by a value corresponding to your current age. This means that as you get older, your RMDs will increase.

It’s important to plan around taking RMDs. If an individual doesn't take an RMD by the required deadline, the IRS will assess a penalty of 25% on the amount of the RMD that was not withdrawn. This penalty can be reduced to 10% if corrected within a two-year window.

Termination distributions (rollovers and cashouts) 

When a participant is no longer employed with the company, they're entitled to receive their vested account balance from the plan. Some plans may state that a participant has to be separated from service for a time period, but most 401(k) plans provide for immediate distribution upon termination.

You can choose to roll over your funds to another qualified plan or IRA, or take your vested balance in cash. A rollover is when you transfer the funds from your 401(k) account into another retirement account. This often happens when you change jobs. 

Because a 401(k) is an employer-sponsored plan, you cannot contribute to a 401(k) under your former employer. However, you can roll your 401(k) into your new employer’s 401(k) account or into an IRA to combine your retirement funds into one custodian, which makes it easier to manage. 

You may receive your retirement funds in cash after leaving your job. However, your former employer is required to withhold 20% of the distribution for federal tax purposes as well as state taxes (if applicable). You may also have to pay an additional 10% early withdrawal penalty to the IRS if you are under age 59 ½. This penalty is assessed when you file your annual Form 1040.

It's also possible for individuals between 55 and 59 ½ to withdraw money without incurring a penalty if they’re fired, laid off, or quit a job. Additionally, your withdrawal is still subject to a federal income tax withholding rate of 20% plus applicable state taxes.

It’s important to review your options when you terminate employment with a plan sponsor, as vested balances under a certain threshold, as stated in the document (maximum $7,000), can be forced out of the plan if you do not choose to rollover or cash out your funds.

How transaction-free rollovers can benefit savers

When rolling funds to a new 401(k) plan provider, it’s crucial to consider a few factors about your plan provider, including customer service, account and transfer fees, transparent pricing, and accessible access to your 401(k) account.

At Human Interest, we never charge transfer fees when an individual is interested in rolling over their 401(k) into a Human Interest 401(k) account. We also never charge transaction fees, which can often eat into retirement savings.

What happens if I make an early withdrawal? 

If you make an early withdrawal from your 401(k) that doesn’t qualify for an exception under the IRS, you may be subject to a 10% early distribution penalty assessed on your annual income tax return. You will also need to pay taxes on the amount that you withdraw, as the money you take out is considered taxable income.

Example: If you withdraw $20,000, you'll incur a 10% tax penalty of $2,000. Your $20,000 withdrawal would also be taxed as part of your income in the year of withdrawal. 

When can you withdraw from a 401(k) without penalties? 

It's crucial to understand that while the IRS lists various distributions that do not incur the 10% early withdrawal penalty, individual 401(k) plans are not required to offer all distribution types. Your plan's specific rules will determine which distributions are available to you. The IRS lists several exceptions for penalty-free withdrawals if you are under 59 ½, including:

• You're disabled

• You gave birth to or adopted a child

• You're a disaster victim

• You're a military reservist called to active duty

• You're going through a divorce, and you are court-ordered to split your 401(k) to your ex-partner (known as a QDRO, more on this below)

• You quit your job, and you are at least 55 years old

• You roll over your 401(k) money during a job change

Consider your options before withdrawing from your 401(k)

When considering withdrawing from your 401(k) before 59 ½, it's essential to know your options. Not only will you have to pay taxes on your withdrawal, but you'll also have less time to invest future contributions, and less compound interest will accrue.

401(k) loans

If you need a lump sum of cash for an emergency, consider a 401(k) loan, if offered by your plan. A 401(k) loan allows you to borrow up to $50,000, or half of your vested balance. The primary benefit of a 401(k) loan is that you do not have to pay any taxes or penalties on the amount as long as you repay the amount in full within 5 years on a regular repayment schedule. 

However, your employer can limit the amount and terms of your 401(k) loan, and if you were to leave your place of employment, you would generally need to repay your loan in full upon termination.

It’s important to note that a 401(k) loan is still not an ideal option, but it can be a much better choice than a withdrawal.

Temporarily reduce 401(k) contributions

If you have serious financial constraints—such as credit card debt or student loans—you may want to consider lowering 401(k) contributions for some time before withdrawing funds from a retirement account. Once you’re in a better financial position, you can meet your initial contribution level. If you receive an employer match, you may want to consider reducing your contributions so you're still contributing up to your employer’s matching threshold.

How to request an early withdrawal

If you’re thinking about making an early withdrawal from your retirement account, you should contact your plan administrator or recordkeeper and request a withdrawal. Once you’ve successfully made a withdrawal request, you should receive funds within a few days.

Consider your 401(k) provider

Whether you’re considering taking a withdrawal from your 401(k) due to unforeseen circumstances or you’re just starting to plan your retirement savings journey, knowing the basics of what happens if you decide to withdraw money from your 401(k) account is critical to avoid paying any potential penalties and additional taxes that can affect your retirement. It can also help to work with a financial professional, who may be able to help you consider your options. 

At Human Interest, we offer 401(k) plans with transparent pricing and dedicated support and resources to help small businesses and their employees prepare for their financial futures. Contact us today to learn more about what we can do for you, or click here to learn more about (k)ickstart, our special cash-back program for eligible participants.