LAST REVIEWED Apr 15 2021 9 MIN READ
By The Human Interest Team
Note: The Coronavirus Aid, Relief, and Economic Security (CARES) Act, recently passed into law:
Waives the 10% early withdrawal penalty
Allows retirees to forgo taking Required Minimum Distributions (RMDs) from a 401(k) (or other qualified accounts) in 2020.
A 401(k) is a type of investment account that’s sponsored by employers. It lets employees contribute a portion of their salary before the IRS withholds funds for taxes, which allows interest to accumulate faster to increase the employees’ retirement funds. Now, if you have a 401(k), you could pay a penalty if you cash out your investment account before you turn 59 ½. Here’s some more information about the rules you need to follow to maximize your 401(k) benefits after you turn 59 ½.
The 401(k) Withdrawal Rules for People Older Than 59 ½
Most 401(k)s offer employer contributions. You can get extra money for your retirement, and you can keep this benefit after you change jobs as long as you meet any vesting requirements. That’s an important advantage that an IRA doesn’t have. Stashing pre-tax cash in your 401(k) also allows it to grow tax-free until you take it out. There’s no limit for the number of withdrawals you can make. After you become 59 ½ years old, you can take your money out without needing to pay an early withdrawal penalty.
You can choose a traditional or a Roth 401(k) plan. Traditional 401(k)s offer tax-deferred savings, but you’ll still have to pay taxes when you take the money out. For example, if you withdraw $15,000 from your 401(k) plan, you’ll have an additional $15,000 in taxable income that year. With a Roth 401(k), your contributions come from post-tax dollars. As long as you’ve had the account for five years, Roth 401(k) withdrawals are tax-free.
If you’re still working after you turn 59 ½, you’ll need to follow your 401(k) plan’s rules for withdrawals as well. While you’re still working, the rules could limit the amount you can withdraw or even bar you from making withdrawals completely. The rules may also require you to work at a company for a certain number of years before your account becomes fully vested. With a vested account, all contributions from you and your employer are available for withdrawal. Additionally, your 401(k) plan may have rules about what will happen if your employer decides to end the plan and you receive an involuntary cash-out.
The 401(k) Withdrawal Rules for People Between 55 and 59 ½
Most of the time, anyone who withdraws from their 401(k) before they reach 59 ½ will have to pay a 10% penalty as well as their regular income tax. However, you can withdraw your savings without a penalty at age 55 in some circumstances. You cannot be a current employee of the company that runs the 401(k), and you must have left that employer during or after the calendar year in which you turned 55. Many people call this the Rule of 55.
If you’re between 55 and 59 ½ years old and you are considering a 401k withdrawal from an old employer, you should keep a few things in mind. For starters, doesn’t matter why your employment stopped. Whether you quit, you were fired, or you were laid off, you can qualify for a penalty-free withdrawal. However, you need to meet the age requirement and your employment must end in the calendar year you turn 55 or later.
These rules for early 401(k) withdrawal only apply to assets in 401(k) plans maintained by former employers. The rules don’t apply if you’re still working for your employer. For example, an employee of Washington and Sons usually won’t be able to make a penalty-free withdrawal before they turn 59 ½. However, the same employee can make a withdrawal from a former employer’s 401(k) account and avoid the penalty when he or she turns 55.
You need to remember that assets in an IRA have different rules about penalty-free early withdrawals. That means any funds that you’ve already rolled over from your 401(k) to an IRA probably won’t be eligible for a penalty-free early withdrawal. However, you could qualify for a different exemption based on the rules and regulations for IRAs. You may want to consult your tax advisor to find which exemptions apply to your situation.
You may also want to keep in mind that you don’t need to be retired to avoid paying an early 401(k) withdrawal penalty. If you retire from a company at age 58 or later, you can access the savings in your 401(k) from that company with no penalty. This fact will not change, even if you take a job with another business immediately after you retire.
The rule that requires you to be age 55 applies to the date your employment with a company stopped, not the date when you started taking 401(k) distributions. For example, if you retire at age 50 instead of waiting until 58 or later, you’ll need to pay the penalties for any withdrawals before you are 59 ½.
In some circumstances, you can make withdrawals from more than one 401(k) account with no penalty. For example, you could retire from a company at age 57 and then take a job with a second business immediately. After a year, when you turn 58, you can retire for good and take advantage of penalty-free 401(k) distributions from both companies.
Required 401(k) Distributions
In 2020, no distributions are required even if you’re of the age required typically required to take a withdrawal. Starting in the calendar year you turn 70 ½ years old, withdrawals from your 401(k) become mandatory. The IRS requires the plan administrator for your company 401(k) to start sending you yearly payments from your account. The amounts of these payments are based on your life expectancy and the amount of money in your account. The IRS calls them Required Minimum Distributions or RMDs. They make it more likely that 401(k) investors will receive all the money in their accounts and be able to use it before their deaths.
If you have more than one 401(k), you’ll need to take a separate RMD from each account. If you want to keep earning interest on your money for a little while longer, you can delay your first required minimum distribution until April 1 in the year after you become 72 (it used to be 70 ½). In the years after that, you must begin receiving your payments by December 31.
A 401(k) is an excellent investment when you follow all the rules that come with it. It’s also an effective way for employers to attract outstanding employees. Human Interest can help you provide an affordable, full-service plan for your workers.
For more articles like this one, please visit our Retirement Learning Center for Employees.
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.