Early 401(k) Withdrawals: Risks and Alternatives

a man looking at a golden scale contemplating whether or not to withdraw his 401k

Key Points:

If you withdraw money from your retirement account before age 59.5, it is generally considered an “early withdrawal,” as defined by IRS rules.
Making an early withdrawal from your retirement savings can significantly impact your long-term financial security
What you need to know about the risks, how to plan for 401(k) withdrawals, and alternatives worth considering.

Making an early withdrawal from your retirement savings can significantly impact your long-term financial security. Before deciding, here’s what you need to know about the risks, how to plan for 401(k) withdrawals, and alternatives worth considering.

Risks of Early Withdrawals

If you withdraw money from your retirement account before age 59.5, it is generally considered an “early withdrawal,” as defined by IRS rules. You may be subject to several risks, including penalties and taxes, at both the Federal and state levels.

Here’s what you should consider.

Penalties

In addition to federal taxes, an early withdrawal from a 401(k) plan typically incurs tax penalties of around 10% of the withdrawn amount, according to IRS rules.

Example: If you took a $10,000 loan, you might owe $1,000 (10% penalty) plus ordinary income taxes. This certainly isn't a small amount.

However, there are some exceptions to this penalty, including disability and medical expenses exceeding that exceed a certain percentage of your gross income.

Taxes

The amount you withdraw from your retirement savings is typically considered ordinary income and, therefore, subject to ordinary income taxes.

This can increase your tax liability and potentially push you into a higher tax bracket. Check out this tax bracket calculator to help you determine if you may be subject to any tax bracket changes.

Some states may also have 401(k) withdrawal tax and penalties. Doing thorough research before making an early 401(k) withdrawal is critical.

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Financial Planning

Financial planning is essential to avoid early withdrawals from your 401(k). These withdrawals can significantly impact your long-term retirement savings.

You should consider financial planning before and after you make a withdrawal.

1. Assess Your Needs: Determine if the early withdrawal is necessary. Explore other options like emergency funds, personal loans, or budget adjustments.

2. Understand the Costs: Calculate the taxes and penalties associated with the withdrawal. This includes the 10% early withdrawal penalty (if applicable) and the income tax on the withdrawn amount.

3. Evaluate the Impact on Your Retirement Goals: Early withdrawals reduce retirement savings. Use retirement calculators to estimate the long-term impact.

4. Tax Planning: View the tax implications, like increasing your taxable income and moving into a higher tax bracket.

5. Create a Repayment Plan: If your plan allows for a 401(k) loan instead of a withdrawal, create a repayment plan to reimburse your 401(k) account.

7. Plan for Future Emergencies: After addressing your immediate needs, plan to build an emergency fund to avoid future early withdrawals.

8. Review and Adjust: After an early withdrawal, you should revisit and adjust your retirement planning strategies to stay on track.

9. Consider Regulations: Stay up-to-date on 401(k) laws and regulations to avoid potential penalties for withdrawals.

These steps can help minimize the negative impact of an early 401(k) withdrawal and keep your retirement goals in sight.

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Alternatives to 401(k) Withdrawal

Before you withdraw early, some circumstances may allow you to avoid the penalties and taxes mentioned earlier. Alternatives include personal loans, borrowing from family and friends, or even an introductory 0% APR credit card.

401k Hardship Withdrawal

One option is a hardship withdrawal, only for immediate and certain financial needs. You typically must provide documentation proving the hardship and may require your plan administrator's approval.

Common reasons for hardship withdrawal include:

Medical expenses
Purchase of a primary residence
Tuition and educational fees
Prevention of eviction or foreclosure
Funeral expenses
Certain expenses for the repair of damage to your primary residence

If you qualify for a hardship withdrawal, you may be able to get the 10% penalty waived, but taxes still apply.

401(k) Loan

Another great alternative to a 401(k) withdrawal is a 401(k) loan. Unlike a 401(k) withdrawal, a 401(k) loan must be repaid to avoid penalties and taxes.

With a 401k loan, you must pay interest, but you pay the interest to yourself. Your 401k administrator typically sets the interest rate, usually pegged to the current Prime Rate.

But, if you leave your job, you may be required to pay back the loan immediately.

In most cases, you can borrow up to 50% of your vested account balance, up to $50,000. It usually must be repaid within 5 years.

Pros	Cons
Easy Access: It is usually easier to get a loan from your 401(k) compared to traditional loans, especially if you have a poor credit score.	Reduced Retirement Savings: When you take a loan, you lose out on potential investment growth on the borrowed amount.
Low-Interest Rates: The interest rates on 401(k) loans are typically lower than those on personal loans or credit cards.	Repayment Challenges: If you leave your job, the loan usually becomes due much sooner, which can strain you financially.
Interest Paid to Yourself: Unlike other loans, the interest you pay goes back into your 401(k) account.	Double Taxation: The money used to repay the loan is taxed twice - once when you repay it and again when you withdraw in retirement.

Personal Loans

You could consider a personal loan if you don’t want to take a 401(k) loan or make a hardship withdrawal.

Depending on the loan’s purpose, a personal loan could come with a more advantageous interest rate than a credit card.

That said, the rate you ultimately end up paying is driven by several factors, including your credit score, length of the loan, and purpose, to name a few.

There are several well-established personal loan services worth considering. Read several reviews to help you decide which platform suits you best.

You can also check out this personal loan calculator to see how much you may pay.

Pros	Cons
Lower Interest Rates: Personal loans generally have lower interest rates than credit cards, making them a more affordable borrowing option.	Higher Payments: Fixed monthly payments can be higher than the minimum payment on a credit card, which might strain your budget.
No Collateral Required: Most personal loans are unsecured, meaning you don’t need to put up collateral like your home or car	Hard Credit Inquiries: Applying for a personal loan may cause a temporary dip in your credit score.
Fixed Interest Rates: This means predictable monthly payments, aiding budget planning.	Risk of Debt: If not managed properly, it could lead to financial strain.

Credit Card with 0% Introductory APR

For short-term financial needs, opting for a 0% APR credit card instead of a 401(k) loan is an alternative worth considering. However, there are several Pros and Cons you should consider before going down this route.

Pros	Cons
No Interest Charges: You don’t pay interest during the promotional period, which can be a cost-effective short-term solution.	Limited Time Frame: The 0% APR is typically for a limited period (e.g., 12-18 months). After that, the interest rate usually jumps significantly.
No Impact on Retirement Savings: Unlike a 401(k) loan, using a credit card doesn’t affect your retirement funds and their growth potential.	High-Interest Rates Post-Promotion: If you cannot pay off the balance before the promotional period ends, you could face high-interest rates, making it difficult to pay back.
Quick Access to Funds: Credit cards offer immediate access to funds, which can be crucial during emergencies.	Credit Score Impact: High credit card balances can negatively impact your credit score.

Borrowing From a Friend or Family

Another option is borrowing money from friends or family instead of taking a 401(k) loan. While this option has several benefits, mixing family/friends and finances can get tricky.

Pros	Cons
No Interest or Low Interest: Often, loans from friends or family come with no or minimal interest, making them more affordable.	Relationship Risk: Money issues can strain or damage relationships, especially if repayment doesn’t go as planned.
Flexibility: Repayment terms can be more flexible and tailored to your situation.	Lack of Formal Structure: Informal loans may lack clear terms and conditions, leading to misunderstandings.
No Credit Check: Borrowing from loved ones usually doesn’t require a credit check, which is beneficial if you have credit issues.	Limited Amounts: Friends or family may not be able to lend as much as you could access through a 401(k) loan.

Bottom Line

When considering an early 401(k) withdrawal, it's vital to understand the risks and alternatives available to you.

These include hefty penalties, increased tax liabilities, and reduced retirement savings. Early withdrawals can severely impact your financial stability in retirement, so it's crucial to assess all potential consequences before proceeding.

Instead of withdrawing early, explore alternatives such as 401(k) loans, hardship withdrawals, personal loans, 0% APR credit cards, or borrowing from friends or family. Each option has its own pros and cons, and the right choice varies based on your financial circumstances. Remember that your 401(k) is meant for retirement, and safeguarding this investment is key to your future financial security.

FAQ

What qualifies for a hardship withdrawal?

Typical reasons include medical expenses, a home purchase, tuition fees, or preventing eviction.

Can I repay a 401(k) hardship withdrawal?

Unlike a loan, you cannot reimburse your 401(k) for hardship withdrawals.

Are there exceptions to early withdrawal penalties?

Exceptions include disability, certain medical expenses, or a separation from service after age 55.

How does a 401(k) loan work?

You can borrow up to 50% of your vested account balance, up to $50,000. It usually must be repaid within 5 years.

Is it better to take a loan or a hardship withdrawal?

A loan is generally better because it doesn't incur penalties you repay yourself, but it depends on your circumstances.

Article Topics

Personal Finance

Written by Adam Koprucki

Adam Koprucki is a dedicated investor and writer with a deep interest in macroeconomics and options trading. His professional experience includes spending over a decade working at some of the largest investment banks, investment managers, and consulting firms, including: J.P. Morgan, Société Générale, Deloitte Consulting, and The Vanguard Group. His experience includes working with complex financial products such as exotic interest rate derivatives, structured products, and structured credit, and his investing research has been published in Seeking Alpha. He has a bachelor's degree, majoring in Finance, from Loyola University, and a Certificate in Capital Markets from the University of North Carolina, Chapel Hill.