A 401(k) plan is a popular type of retirement plan. It is part of a group of qualified retirement plans confirming to the laws outlined in the Employee Retirement Income Security Act of 1974 (or ERISA). To qualify for a 401(k) plan, the company you work for must offer it. If the 401(k) plan is available, you can opt to deposit portions of your wages into the account.
Your employer can also add funds to the account. When you retire, you can collect these funds to pay for your retirement living expenses.
Although not typically recommended, it is possible to borrow early from your 401(k). However, you incur penalties by doing so. You must understand the implications of early funds withdrawal before choosing this option. For instance, early withdrawal prevents your 401(k) from growing to its full potential, preventing you from collecting your full benefit at maturity. Below is information you need to know about the full impact of borrowing early from your 401(k) and when doing so may benefit you.
401(k) Standard Withdrawal Rules and Loans vs. Early Withdrawals
Typically, you cannot withdraw funds early from your 401(k) plan anytime you wish. In order to be eligible for fund withdrawal, you must meet one of the parameters required for withdrawal. Those parameters are called triggering events. The following are the common triggering events for a 401(k) plan:
- Reaching 59-and-a-half years of age.
- Retiring from your place of employment or separating from the company in any way.
- Passing away.
- Becoming disabled.
- Having your 401(k) plan terminated for any reason.
- Experiencing an extreme financial hardship (only applicable if your 401(k) plan includes hardship withdrawal claims).
If a triggering event occurs, you are eligible to withdraw funds from your 401(k) early. However, doing so is not necessarily in your best interest. For example, if your 401(k) plan includes the option, you may take out a temporary loan from your 401(k) plan, rather than permanently withdrawing funds early. If such a loan is an option under the provisions of your 401(k) plan, the following rules apply:
- You may borrow up to $50,000, if the funds are available and other rules are met.
- You may only borrow up to 50 percent of the available vested funds in your 401(k) account. You cannot borrow the full $50,000 unless you have a 401(k) balance of $100,000 or more.
- The terms of the loan require you to repay portions of what you borrow at least once per quarter.
- Full repayment is required within five years of the initial loan agreement.
- The length of the loan is only extendable if you borrow the funds for the specific purpose of purchasing a home.
- Failure to repay the loan on time or leaving the company you work for before the loan is repaid results in additional penalties and taxes.
Tax Implications and Other Penalties of Early 401(k) Withdrawal
In the case of a 401(k) loan, you can avoid heavy tax penalties by paying the loan back on time. Similarly, there are tax penalties for permanently withdrawing funds from your 401(k) plan early. However, there are some scenarios where you can avoid these penalties. The Internal Revenue Service (IRS) typically charges a 10 percent tax penalty for early fund withdrawal. If you withdraw $10,000, the IRS charges a $1,000 penalty. Additionally, you are required to pay the standard income tax rate on the funds you withdraw. When coupled with the losses incurred by not allowing the 401(k) plan to mature to its full potential, it is clear why early 401(k) withdrawal is best done as a last resort.
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If you must withdraw 401(k) plan funds early, you can avoid the 10 percent penalty charged by the IRS if you qualify for exemption. You cannot incur the 10 percent penalty if you are 55 years of age or older and cease working for the company providing your 401(k) plan. You may also qualify for an exemption from the penalty if you have medical expenses. These expenses must exceed your gross adjusted income by more than 10 percent. A third scenario where you are exempt from the IRS penalty is if you become permanently disabled.
The Impact of 401(k) Vesting Schedules on Early Withdrawals
You can only withdraw vested funds from your 401(k) account. Vested funds are funds you own. Any funds you deposit into a 401(k) from your wages are vested by definition. Funds deposited by your employer are not automatically vested. They are released on a vesting schedule established by your employer. You are required to work for your employer for a set number of years before all funds in your 401(k) plan become vested.
There are two widely-used types of employer vesting schedules. They are graduated vesting and cliff vesting. Graduated vesting allows you to receive a set percentage of vested funds for each successive year you work for a company. The percentage increases each year, so you are encouraged to continue working for the company for a long period. Cliff vesting is a short-term vesting schedule. Under a cliff vesting plan, no employer-deposited funds are vested to you for a set period. Then, all funds are vested to you at once. Typically, the zero percent vesting period lasts for a few years, but you must check the rules established by your employer for specific details.
Scenarios When Withdrawing Funds from a 401(k) Early is an Acceptable Option
If you meet one of the triggering event scenarios allowing early 401(k) withdrawal, you must decide if withdrawing the funds is worth it for you. There is no time when pulling money from your retirement fund before you retire is good. However, there are scenarios where early withdrawal is necessary or helpful, such as:
- You no longer work for the employer providing the 401(k) plan and wish to roll the funds over into an IRA account.
- The 401(k) funds are necessary because you are deeply in debt and have poor credit.
- You are faced with a sudden and severe financial hardship, such as a major medical expense, and have no other feasible way to pay for the expense.
If you are considering withdrawing 401(k) funds early to help yourself recover from debt, you must assess your spending habits. Using your 401(k) funds in such a manner may help you once. However, the long-term 401(k) benefits you lose in the process may negate your temporary debt relief. If you do not develop a clear plan to stay out of debt with a financial adviser, you may also find yourself back in debt at a later date.
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By Alfred Wickham –