LAST REVIEWED Dec 13 2019 9 MIN READ
By The Human Interest Team
401(k) plans and other pre-tax retirement savings accounts are something almost all American workers have heard about at one time or another. Plans like these are among the most common ways to save for retirement, and millions of people are putting money into these plans every year. If you think a 401(k) may be the solution you’re looking for, it’s important to consider the 401(k) withdrawal rules when it comes to actually enjoying those retirement savings. Here’s everything you need to know about the 401(k) withdrawal rules.
Reasons for a 401(k) Withdrawal
Withdrawing money from a 401(k) doesn’t always happen just at retirement. One of the most common reasons for withdrawal is buying a home. Putting a down payment on a house is no easy task without some extra funding. Most of the time, however, withdrawals happen for an unexpected emergency expense. When these early withdrawals happen, you often have to forfeit some benefits from contributions and incur increased tax penalties.
Types of 401(k) Withdrawals
In total, there are four primary types of 401(k) withdrawals and each of them have different 401(k) terms of withdrawal to consider. To best prepare for your future, it’s a good idea to make sure you understand 401(k) hardship withdrawals, penalty-free withdrawals, required minimum distributions, and 401(k) distributions in retirement, as well as the risks and benefits of each.
401(k) Hardship Withdrawals
401(k) hardship withdrawals are intended to cover emergency expenses. The primary reason for a hardship withdrawal is an emergency medical expense. It doesn’t have to be your own medical expense, either. Spouses and dependents are covered as well. Mortgage payments and tuition payments for the plan holder, their spouse, and their children are also valid reasons for taking money out of a 401(k) plan. Just keep in mind that this 401(k) distribution will be taxed as regular income.
While any of the aforementioned reasons can be justification for a hardship withdrawal, you’ll need to get approval from your employer first, which typically involves showing your employer financial proof that you need the money. If you’d rather not show your finances, you can self-certify. While you get to keep your finances private in that case, you can’t make any more contributions to your 401(k) for six months after making the withdrawal. Of course, the qualifications and whether or not hardship withdrawals are even allowed in the first place will vary from company to company.
In short, penalty-free withdrawals are the withdrawals you can make before you’re 59 ½ without having to pay the 10% penalty. While this certainly sounds nice, it’s important to remember that they’re not tax-free and that there are qualifications to meet first, such as taking a distribution before age 59 ½. Various situations can help you qualify, including having a disability, medical expenses allowable as an expense deduction, and court-ordered payments to an ex-spouse, a child, or a dependent. These withdrawals are also justified if you are affected by a disaster that qualifies for relief by the IRS, or in the event that you die and your plan pays to your beneficiary.
Similar to hardship withdrawals, penalty-free withdrawals will vary based on your company’s specific policies. There may be additional qualifications you have to meet first, or the option may be entirely unavailable altogether. Remember that even if you terminate your employment and are at least 55, which is one of the possible qualifications for a penalty-free withdrawal, you’ll still have to deal with the employer that initially supplied your 401(k).
Required Minimum Distributions
Once you reach the age of 70 ½, you are required by law to start taking money from your 401(k) regardless of whether or not you want to. While there are rules regarding the maximum you can take that will vary based on the situation, you must take your Required Minimum Distribution, or RMD. For the most part, RMD is calculated based on your projected life expectancy and your total account balance at the end of the previous year.
You can find out your RMD by contacting the financial institution in control of your 401(k) account, as they have to report it to the IRS. If you want to calculate it for yourself, however, you can use the IRS’s resources. They can provide you with the necessary information for making the appropriate calculations. Take note that these distributions don’t have to start until April 1 of the year following your 70 ½ age date. Should you fail to withdraw the RMD, you can incur penalties up to 50% of the difference between your RMD and the amount withdrawn.
401(k) Distributions in Retirement
There are several routes available regarding 401(k) withdrawal options at retirement. Once you retire and are at least the age of 59 ½, you have the option to take 401(k) payout distributions periodically or as one lump sum. Periodic distributions will require confirmation from the employer who administers the account, but once that’s achieved, you can customize how much you want to receive by month or by quarter, in most cases. Typically, you can change that amount once a year, but some companies may allow you to make changes even more frequently than that.
Early Withdrawal Penalties
Withdrawing from a 401(k) early (before the age of 59 ½) usually incurs penalties. The most common penalty is the 10% penalty imposed in accordance with the IRS 401(k) withdrawal rules. Remember, this is the 10% penalty that penalty-free withdrawals are designed to avoid. Even then, however, your withdrawal is not entirely tax-free. Income tax still applies to the amount, which, for some people, can mean only receiving about half of the money they withdrew.
One of the most impactful penalties to remember is the loss of potential. When you withdraw from a 401(k) account early, you lose future investment growth. This is because there are limits to how much you can contribute to a 401(k) in a year. If you want to contribute an equal amount to that which was previously withdrawn early, you simply won’t be able to if it exceeds your contribution limit.
Planning for 401(k) Withdrawals
If you’re looking for 401(k) plans that allow for certain kinds of withdrawals that abide by 401(k) liquidation rules, Human Interest is happy to help. Our mission is to help small businesses find employee retirement plans that work for them and their workers in equal measure. Contact us today to get started!
The Human Interest Team
We believe that everyone deserves access to a secure financial future, which is why we make it easy to provide a 401(k) to your employees. Human Interest offers a low-cost 401(k) with automated administration, built-in investment advising, and integration with leading payroll providers.