What to Know About Cashing Out 401(k) Plans Before Retirement

Most people contribute money to a 401(k) plan and don't expect to see it again until after they turn 59½. However, in some cases, you might consider cashing out 401(k) accounts early, even if it requires paying some extra fees or taxes.

For instance, if you're facing extreme financial hardship, a 401(k) early withdrawal could become necessary. Ahead of facing an emergency situation, it can be helpful to understand when you're able to pull money from your retirement savings — and what the consequences could be for dipping into your retirement savings early.

Here's a deep dive into the rules for cashing out your 401(k) accounts before and after the typical retirement age.

What to Know About 401(k) Withdrawal Rules

Most people only think about cashing out 401(k) plans once they've turned 59½ years old, the IRS-designated age when savings can be accessed penalty-free.¹ You may also become eligible to withdraw from your account when your employment has ended, whether you retire or become disabled.²

While there are no penalties for taking 401(k) distributions after age 59½, you may have to pay taxes on your withdrawals depending on what type of account you have. Withdrawals from a traditional 401(k) are subject to income tax, but withdrawals from a Roth 401(k) are not if made after age 59 1/2 and at least 5 years after the first contribution to the Roth account. This means you may want to withdraw from Roth accounts first before taking money from a traditional 401(k). This strategy could potentially help to reduce the amount you pay in taxes over your lifetime.

As you consider your options, don't hesitate to work with a qualified financial professional who can help you create a personalized retirement income strategy.

What Is the Penalty for Cashing Out a 401(k) Early?

The IRS defines an early withdrawal as any withdrawal from a retirement plan before the account holder is 59½ years old.³ In most cases, an early withdrawal will be subject to a 10% penalty — and that fee is stacked on top of the income tax you may already owe on the withdrawal itself.

To take an early withdrawal, you may need to qualify for a hardship distribution. Not all 401(k) plans allow for early hardship distributions; it's an optional feature that some plans allow. If you're unsure whether your plan allows it, check with your plan's administrator.

Qualifying for Early Withdrawal With a Hardship

If your plan does permit hardship withdrawals, you must be deemed to have an "immediate and heavy" financial need based on the terms of your plan.⁴ For example, a consumer purchase is unlikely to be deemed a financial need, but medical expenses or funeral expenses within your immediate family could qualify for early 401(k) distributions.

The IRS designates six types of hardship that automatically rise to the level of "immediate and heavy" need:

• Medical expenses for yourself, a spouse or a dependent
• Some expenses to repair home damage
• Some expenses related to the purchase of a primary residence
• Payments to prevent eviction or foreclosure
• Costs related to funeral expenses for yourself, your spouse or a dependent
• Tuition and educational fees for yourself, your spouse or a dependent

You may also be required to prove that your early 401(k) withdrawal is truly a last resort. Some plans require a written statement declaring that you've exhausted all other sources of financial aid, including insurance benefits, loans and liquidating your assets.

Limits to Early Withdrawals

If you find yourself in a situation where you need to pull money early from your 401(k), it's important to understand the rules governing how much you can take out. You can generally only pull from the elective deferrals you've made into the account and the accumulated employer contributions, including matching and profit-sharing contributions.

You can't pull from the account earnings. If your account balance includes a significant amount of interest, this could limit the total amount you're able to withdraw early.

Plans that allow for hardship distributions also limit the withdrawal to the amount necessary to cover your hardship. Don't plan on taking out any extra amount to put toward other uses.

What Is the Process to Withdraw From 401(k) Plans? Are There Minimum Withdrawals?

The process to receive money from your 401(k) can vary across plan administrators. Generally speaking, though, it can work a few different ways.

Withdrawing Money During Retirement

Once you retire and/or reach age 59½, you have several options for how to manage the money in your 401(k).

Some people choose to keep their money in the plan or roll it over into an individual retirement account (IRA). You can also convert your account into an annuity or withdraw some or all of the balance of your account. Just remember that you will have to pay income tax on withdrawals from a traditional 401(k).

If you don't begin withdrawing money right when you retire, you will eventually be required to take minimum distributions from the account each year starting at age 73. Your minimum distribution amount will vary; the IRS calculates minimum distributions based on life expectancy.⁵

How fast will your 401(k) distribution arrive? Expect at least a few business days from when you initiate the transfer or check with your financial institution for a more accurate estimate.

Withdrawing Money Early

Work with your plan's administrator to make sure your 401(k) allows early withdrawals for hardship. If you qualify for a withdrawal, your employer or plan administrator can provide detailed instructions on how to obtain money. They can also tell you how quickly to expect the money in your account after initiating a transfer.

How Does Cashing Out a 401(k) Affect My Tax Return?

Whether you make an early withdrawal or wait until after age 59½ to dip into your 401(k) money, any distribution from a traditional, non-Roth 401(k) account is subject to both federal and state income taxes.⁶ For any withdrawal greater than $10, your plan administrator will issue a Form 1099-R to report the amount cashed out.⁷

When it's time to file your taxes, you'll report withdrawals of pre-tax 401(k) amounts as income on your tax return. There is one exception to this rule: If you directly roll your 401(k) into another retirement account, you won't owe taxes or report the withdrawal as income on your tax return.

Exceptions to Early Withdrawal Penalties

Not every early withdrawal from a 401(k) plan is subject to a fee. The IRS has outlined some situations when early withdrawals are allowed with no penalties. These exceptions include:¹

• Death of the plan owner
• Disability of the plan owner
• Some distributions to military reservists called to active duty
• Plan rollovers

An important note: The IRS allows some early payouts from IRAs that are not allowed from 401(k) plans. For example, qualified first-time homebuyers may be able to withdraw early from an IRA account without penalties, but this exception does not apply to early distributions from a 401(k). Follow the IRS's guidance to see which exceptions apply to different types of retirement accounts.

Another Option to Consider: 401(k) Loans

Depending on the details of your 401(k) plan, you may be eligible to take out a 401(k) loan. This type of loan allows you to borrow from your account balance.⁸ You can borrow up to 50% of your balance or up to $50,000, whichever is less. You generally have to pay back your loan and any interest accrued within five years. This may be an option worth considering if your plan allows 401(k) loans and you are considering an early withdrawal for hardship.

When May It Be Worth Cashing Out a 401(k) Early?

If you're facing a financial emergency and you've exhausted all your other options, you might be debating whether to withdraw money early from your 401(k) even if you're still many years away from retirement.

Before you seriously consider an early withdrawal, remember to confirm if your 401(k) plan allows it. Some — but not all — 401(k) plans allow for hardship withdrawals in certain situations, such as mounting medical debt or to prevent eviction or foreclosure on your home.

Keep in mind that if you pull money from your retirement account early, you're taking money from yourself in the future. The less money you have in your retirement accounts today, the less opportunity you have to earn interest by investing that money. Plus, you could lose even more money when you factor in the 10% early withdrawal fee you will pay on top of income tax.

It can also be hard to recoup the money you withdraw early, especially if you've spent decades making regular contributions to your retirement plan. For some people, the negative effects are cumulative: With the extra penalties, opportunity cost when withdrawing invested money and ultimate loss of retirement income, you may decide that an early 401(k) withdrawal is not worth it.

If you are striving to avoid cashing out your 401(k) early, look into other options to help with your hardship. Personal loans and payment plans are two possible ways to manage debts. Home equity loans are a popular option for many people seeking access to capital. For medical bills, you can reach out directly to the billing departments at hospitals or clinics to try to come up with a payment plan or negotiated balance. If you are funding higher education for yourself or a loved one, look into other sources of aid, such as scholarships, grants and federal and private student loans.

Your plan may also allow you to take out a loan against your 401(k), which could provide an alternative to taking out 401(k) money early. Weigh the pros and cons of all your various options as you consider your choices.

Bottom Line

Ultimately, if you're considering an early withdrawal from a retirement account, it's a good idea to meet with a qualified financial professional to assess your specific situation. Cashing out a 401(k) early can be a good strategy for some people, but for many, it's a last resort.

Sources

1. Retirement topics: Exceptions to tax on early distributions. https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-tax-on-early-distributions.
2. When can a retirement plan distribute benefits? https://www.irs.gov/retirement-plans/plan-participant-employee/when-can-a-retirement-plan-distribute-benefits.
3. Here's what people should know about taking early withdrawals from retirement plans. https://www.irs.gov/newsroom/heres-what-people-should-know-about-taking-early-withdrawals-from-retirement-plans.
4. Retirement topics — hardship distributions. https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-hardship-distributions.
5. Required minimum distribution worksheets. https://www.irs.gov/retirement-plans/plan-participant-employee/required-minimum-distribution-worksheets.
6. Roth comparison chart. https://www.irs.gov/retirement-plans/roth-comparison-chart.
7. About Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. https://www.irs.gov/forms-pubs/about-form-1099-r.
8. 401(k) loans, hardship withdrawals and other important considerations. https://www.finra.org/investors/learn-to-invest/types-investments/retirement/401k-investing/401k-loans-hardship-withdrawals-and-other-important-considerations