A guide to 401(k) withdrawal strategies 

A vast majority of American workers participate in and rely on 401(k) plans to grow and fund their retirement. The way 401(k) plan participants maximize its benefits is to contribute enough of their salary to get the employer match, choose the most stable investments, and leave the plan to grow tax-free.  

Ideally, employees who participate in their company-sponsored 401(k) would allow it to earn undisturbed, until they can take distributions from it upon their retirement.   

But not all employees have the same financial or personal circumstances. There may be times when they may need to make partial or total early withdrawals from their 401(k) account.  

What are the 401(k) withdrawal rules? Is there a penalty for an early 401(k) withdrawal? How can you withdraw money from a 401(k) before retirement? InvestmentNews provides answers to these and more in this article.  

Types of 401(k) withdrawals 

Employees with a 401(k) may be tempted to take out some money from the plan, but not everyone withdraws from the plan on a whim. (No financial advisor would recommend this, by the way.) Why would employees take out money prematurely from a retirement plan that’s designed to give them a more secure financial future?  

There are a few instances where this is necessary. When a 401(k) plan holder does this, there are corresponding penalties.  

There are at least three types of withdrawals that a 401(k) plan holder might commonly do:  

• hardship withdrawals 
• early withdrawals 
• loans on the 401(k) 

Hardship withdrawals 

As the name implies, these are withdrawals from a 401(k) due to an urgent financial need. Hardship withdrawals or distributions are limited only to the actual amount needed to fill that need.  

The amount taken in a hardship withdrawal is charged the 10% tax penalty, but the account holder is not obligated to pay back the amount. Hardship withdrawals can be done for reasons like:  

• paying medical or funeral expenses 
• making rental or mortgage payments to avoid eviction or foreclosure, as appropriate 
• repairing an employee’s home after a calamity 

Early withdrawals 

This is a plan distribution or withdrawal done by the account holder before they reach the retirement age of 65. This is the average age when most American workers retire. When an employee makes an early withdrawal before reaching the age of 59½, then a penalty of 10% is imposed on the withdrawal.  

Early withdrawals count as 401(k) distributions, so these are also subject to taxes.

Loans 

A 401(k) plan holder can take money from their account as a form of retirement plan loan. This is best done only as a last resort. These loans must be paid back, and a 10% penalty would need to be paid on this early withdrawal.  

If the plan holder follows certain rules and adheres to the repayment schedule, the money taken out as a loan is not taxed. Plan holders be warned: your plan sponsor (your employer) is not obliged to place loan provisions on their 401(k).  Plan holders should check their Summary Plan Description to see if their 401(k) allows loans.  

Can I make an early 401(k) withdrawal? 

In general, anyone can make an early 401(k) withdrawal, but that does not mean that they should. There are rules and consequences to these withdrawals. 

The Rule of 55 

This rule regarding the 401(k) was created by the IRS and applies in situations where plan holders lose or leave their jobs before they reached age 59½.  

We are now aware that taking money out this way – early withdrawals – before reaching age 59½ means that plan holders will take a 10% penalty apart from paying the taxes they owe.  

This is when the Rule of 55 applies. Should a worker be aged 55 or older (but still younger than 59½) during a calendar year that they leave or lose their job, they can receive distributions from their 401(k) without the penalty. They would still have to pay income tax on the withdrawals.  

This rule of 55 applies to the 401(k) and other qualified retirement plans like its nonprofit-organization-cousin, the 403(b). Plan holders should check their Summary Plan Description to see if their 401(k) plan allows for this feature.  

Read more: Similarities of 401(k) and 403(b) plans 

Cases where the early withdrawal penalty is waived 

Even if a plan holder is not yet the age of 55 and loses or leaves their or job, or is already aged 59½, these are the cases where their withdrawals can be free from any penalty:  

• withdrawals are made after the plan holder suffers total and permanent disability 
• the plan holder has unreimbursed medical expenses costing more than 7.5% of adjusted gross income 
• the plan holder leaves or is dismissed from service at age 55 or older (age 50 for most public safety employees)  

The penalty-free withdrawal applies only on the plan at the job the employee is dismissed from or leaving. These penalty-free withdrawals are mainly extreme and uncommon situations. But thanks to the SECURE Act 2.0's retirement-benefitting provisions, employees can withdraw some 401(k) money in more situations without penalty.  

As mandated by the SECURE 2.0 Act, starting in 2024, these are the added instances where employees can withdraw from their 401(k) without paying the 10% penalty:  

• employees with financial emergencies can have one withdrawal per year of up to $1,000 
• victims of domestic abuse within the past 12 months can withdraw up to $10,000 or 50% of their account, whichever is lesser 
• an employee in a federally declared natural disaster area can withdraw up to $22,000 

• an employee diagnosed with an illness that will likely cause death within seven years 

There are a few more scenarios that allow for penalty-free 401(k) withdrawals. You can learn more about them in this video. The presenter emphasizes that you should never withdraw any money from your 401(k) unless it is a life-or-death scenario. Find out why:  

 These situations allow plan holders to withdraw without penalty, but the money must be repaid (except for terminally ill cases). Employees who make these penalty-free withdrawals typically must adhere to a repayment schedule that lasts three years.  

Why plan owners should avoid making early withdrawals 

Withdrawing from a 401(k) is hardly ever a good idea. The 401(k) is one of the best investments for employees, but only if they contribute to it and don’t withdraw funds.  

If your client urgently needs money for an emergency and has no other recourse, it’s better for them to take out a loan from their 401(k) plan instead of withdrawing the needed amount.  

Still, borrowing money from a 401(k) has serious implications:  

The plan owner has their income decreased  

Most 401(k)s work by having contributions deducted from employees’ paychecks. When borrowing from a 401(k), the monthly take-home pay is reduced by the contributions and the amount borrowed. If an employee already has financial troubles, taking a loan may create an added pay cut that could worsen their situation. 

The plan owner can miss out on contributions and the employer match 

Some 401(k) plans don’t allow plan participants to make contributions while they have an outstanding loan on the plan. Depending on the size of the loan and its repayment schedule, this could seriously impact the plan holder’s retirement savings.  

For instance, if the loan is payable in 3 years and the plan doesn’t allow for contributions while the loan is not repaid, then the plan receives no contributions and the employer match for that period.  

The plan holder misses out on investment returns 

If a 401(k) doesn’t allow for contributions if the plan holder takes a loan on it, then they cannot make the plan grow and miss out on the employer match. By doing so, the 401(k) misses out on a lot of potential growth, and the required minimum distributions (RMDs) will be a lot smaller when the plan holder retires. 

Plan holders may have to pay additional fees 

Many 401(k)s charge origination fees along with quarterly maintenance fees on the loans they provide. Fees like these can significantly increase the cost of borrowing money from your 401(k). 

There are potential tax consequences 

Let's say your client leaves a job with an outstanding loan on their 401(k). They have a limited time window in which to repay the loan.  

Typically, they'd have to repay the loan by the time the next tax return is due or roll over the 401(k). If your client is unable to pay the loan by their next tax return, the employer can treat the loan as a distribution. The loan also incurs the 10% tax penalty on the outstanding balance.  

Maximize contributions by avoiding 401(k) withdrawals 

Savvy advisors should make clients realize that withdrawing from their 401(k) often leads to undesirable outcomes. As much as possible, investors should avoid making early withdrawals or taking out a loan on their plan. Continuing to max out contributions to get the 401(k) employer match is crucial, especially for older clients who may have a longer life expectancy.  

One way to prevent unnecessary use of the 401(k) for emergencies is for advisors to find other investments to create an emergency fund or boost their retirement savings if their budget allows. 

The only scenarios that make 401(k) loans or withdrawals justifiable are those that the IRS and SECURE Act 2.0 give leeway for penalty-free withdrawals. Ideally, 401(k)s should be left to grow tax-deferred earnings until the plan owner’s retirement.  

Help secure your clients’ 401(k)s by using the best investment research platforms to give their savings and emergency funds a boost.