What is a 401(k) Early Withdrawal Penalty?

Sometimes life throws you an expensive curveball. If you don’t have enough in your savings to cover a large expense or a financial emergency, it can be tempting to dip into your 401(k) account.

But if you’re not careful, withdrawing from your 401(k) can be costly. Because a 401(k) is a retirement plan, it’s designed to discourage you from withdrawing the money before you turn 59 ½. In many cases, you’ll have to pay a penalty if you try to withdraw the funds early — but there are exceptions.¹

In this article, we’ll help you understand what the 401(k) early withdrawal penalty is and the circumstances under which you may be able to avoid it.

What is a 401(k)?

A 401(k) is a retirement plan offered by employers that allows employees to invest pre-tax income to use after they stop working. Your employer may even match a certain percentage of your contributions.

Some employers also offer a Roth 401(k), which lets you deposit after-tax money. However, since there are very few exceptions for penalty-free early withdrawals for Roth 401(k)s, we’ll be focusing on the exceptions for traditional 401(k) plans.²

What is the early withdrawal penalty for 401(k) plans?

The 401(k) early withdrawal penalty is a 10% tax you pay if you withdraw money from your retirement account before reaching the age of 59 ½.³ This is in addition to other federal and state income taxes you may owe, since the amount you withdraw is added to your other taxable income for the year.⁴ The penalty doesn’t apply to every scenario, however. There are some exceptions that may allow you to withdraw money from your 401(k) early. You should always check the latest IRS rules and talk to your 401(k) plan administrator to see if your reason qualifies for an exception.

Exceptions to the 401(k) early withdrawal penalty

Exceptions to the 401(k) early withdrawal penalty generally fall into three buckets: hardship reasons, administrative reasons and establishing a substantially equal periodic payment (SEPP) plan.⁵

Hardship

Many employers allow their employees to take an early withdrawal from their 401(k) plans in the event of a personal hardship — defined by the IRS as an “immediate and heavy financial need.” Common reasons for hardship withdrawals that the IRS recognizes include the following:⁶

Medical expenses

You may be able to tap into your 401(k) without penalty to cover certain medical costs, such as:

• Becoming totally disabled
• Being diagnosed with a terminal illness
• Facing unreimbursed medical expenses that exceed 7.5% of your adjusted gross income (AGI). AGI is your total income minus certain tax deductions and expenses.

Family expenses

There are times in life when big life changes can be costly. You may be able to withdraw money from your 401(k) without penalty in some cases, such as:

• Having a baby or adopting a child
• Paying for a spouse or dependent’s funeral
• Starting over after domestic abuse
• Being called to active duty as a military reservist or National Guard member
• Making a down payment on a house
• Paying for college education costs for yourself, your spouse or your child

Disasters and emergencies

You may avoid paying a penalty on 401(k) early withdrawals in certain emergency situations, such as:

• Recovering from a federally declared natural disaster
• Specific small personal emergency expenses
• Avoiding foreclosure or eviction

Administrative reasons

There are a variety of administrative reasons you may be able to take money out of your 401(k) without penalty, such as:⁷

• Rolling over your 401(k): When you leave a job, you have the option to cash out your old 401(k) and invest the funds into your new employer’s 401(k) or a personal Individual Retirement Account (IRA) without penalty.
• Correcting an over-contribution to your plan: If you accidentally put more than the maximum amount into your 401(k) for the year, you can avoid paying a penalty on the refund if you request it right away.
• Dividing your 401(k) as part of a divorce settlement: If you must give your ex-spouse a portion of your 401(k) during a divorce, you won’t pay a penalty for withdrawing that amount.

Substantially Equal Periodic Payments (SEPP) plans

If you think you’ll need to pull money from your 401(k) over a long period of time before age 59 ½ and don’t qualify for a hardship — for example, if you retire early — you might consider a SEPP plan.⁸ A SEPP plan allows you to receive regular fixed payments from a previous job’s 401(k) without penalty for 5 years or until age 59 ½, whichever is longer. A SEPP plan is intended for someone who needs ongoing income from their retirement account, not for someone who needs to withdraw a lump sum for a specific use.

SEPP plans have very strict rules and require a significant commitment: You can only change your SEPP plan in very limited ways, and if you cancel your SEPP plan, you’ll owe penalties and interest on everything you’ve withdrawn. And, as with any traditional 401(k), your withdrawals will be taxed as income. Before considering a SEPP plan, it’s a good idea to speak to a financial advisor.

Why you might have to pay the 401(k) early withdrawal penalty

If you take money out of your 401(k) for a reason that doesn’t qualify as an exception, you’ll likely have to pay the 10% penalty. Here are some common instances where this might happen:

• Covering a non-essential personal expense: If you want to buy a new car or pay for a big wedding, this will likely not qualify for a hardship distribution.⁹
• Cashing out a 401(k) when changing jobs: While you can roll over a 401(k) without penalty, if you choose to simply cash it out, you will need to pay.¹⁰
• Your employer doesn’t offer hardship withdrawals: The IRS allows employers to offer hardship withdrawals, but it doesn’t require them to. If your employer’s plan doesn’t, you’ll have to pay the penalty to make an early withdrawal.¹¹

How to avoid the 401(k) early withdrawal penalty

The best way to avoid paying a penalty for an early withdrawal from your 401(k) is to make sure your reason qualifies for an exception. If it doesn’t, you might consider alternative ways to get the funds you need. Here are a few options:

Borrow against your 401(k)

Rather than withdrawing funds from your 401(k) plan, you might be able to borrow against your retirement account by taking out a 401(k) loan instead. Some employers will let you borrow up to a specific amount of your current 401(k) balance for up to five years. 401(k) loans tend to be relatively inexpensive because you’re paying the interest, or the cost of borrowing money, to yourself. And because you’re lending to yourself, there’s typically no credit check.¹²

However, if you lose your job or change jobs, you may have to pay your entire loan back within a very short amount of time. By withdrawing funds, you also lose out on any potential gains your full 401(k) balance might have earned if you hadn’t taken the withdrawal. And if you default, meaning you fail to repay according to the terms of your loan, you may owe the early withdrawal penalty and taxes on the amount you haven’t paid back.

Consider other ways to cover your expense

Instead of reducing your 401(k) balance, consider whether other types of financing might work better for you, such as:

Personal loan

A personal loan is a lump sum of money that you can use for a wide range of scenarios, such as consolidating debt, paying a medical bill, and more. Personal loans may be secured or unsecured. Secured loans require collateral—something valuable that you have, such as a car. If you fail to repay the loan, the lender has the right to take your collateral. Unsecured loans are made based on factors like the borrower’s credit history, income, and debt-to-income ratio. A secured loan may offer a larger borrowing amount and lower interest rate than an unsecured loan, especially for people with less-than-perfect credit. Both secured and unsecured loans give borrowers predictable payments and a set payoff date.

Credit card

If the amount of your expense is less than your credit limit, using a credit card could give you the flexibility to cover the cost and take as long as you need to pay it off, as long as you make the minimum monthly payments. However, it’s important to remember that credit card interest is added to your unpaid balance every month and can accumulate very quickly. This could increase your debt more than you intended and make it difficult to create and budget for a repayment plan.

Home equity line of credit (HELOC) or home equity loan

If you own property, you may be able to borrow against the equity in your home. Equity is the value of your home minus the amount you may owe on a mortgage. HELOCs and home equity loans are both types of secured credit that use your home as collateral. A home equity loan allows you to borrow a lump sum upfront and repay it over a fixed term. A HELOC is a form of revolving credit, like a credit card. With a HELOC, you can borrow as much as you need up to your credit limit, repay it and borrow again over a set period of time. Keep in mind that if you can’t pay back what you owe, the lender could take your house.

Plan ahead

While life is unpredictable, there are some ways you may be able to prepare for big expenses down the line. For example, if you have children, consider setting up a college savings plan for them. You might also want to open a savings account specifically for emergencies or set up a sinking fund to help you save for a wedding or a down payment on a house.

Once you open your savings account, consider setting up automatic deposits to transfer a certain amount into it every month to help you stay on track. Even if you can only set aside a few dollars at a time, every little bit can help.

Finally, take some time to review your budget. You may find areas where you can spend a little less so you can save a little more to pay for emergencies and big upcoming expenses.

What to consider before tapping into your 401(k)

Before you dip into your retirement fund for extra money, it’s important to consider the financial consequences beyond whether you’ll owe the 401(k) early withdrawal penalty.

You pay income tax on early 401(k) withdrawals

A traditional 401(k) is a tax-deferred account, meaning you haven’t paid income taxes on the money that went into it yet. You’ll owe that tax when you take the money out, whether you withdraw early or once you retire.

You may lose more than you take out

Remember that retirement accounts are investment accounts that are intended to grow in value over time.¹³ If you take money out now, you lose not only the amount you withdraw, but also all the gains it might have earned if it had stayed invested.

You can only withdraw your vested amount

"Vested” funds in a retirement plan are the portion of employer-contributed funds that are yours to keep. Some plans allow participants to vest the full amount immediately, while others require them to vest gradually over several years. If you haven’t been with your company for very long, you might not have as much in your 401(k) as you think. Your plan information should include a vesting schedule that you can use to determine how much money you can access.

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Know your options before you withdraw

The rules around withdrawing money early from a 401(k) are strict on purpose. A 401(k) is designed to help you save for retirement, so it’s difficult — but not impossible — to use those funds for other reasons.

If you’re trying to figure out how to cover a large expense, first consider other ways you might be able to pay for it. A line of credit or a personal loan may be a better fit for your financial situation in the long run. OneMain works with a wide range of customer credit scores and takes your whole financial picture into account to help you find a personal loan that’s right for you.

For most people, making an early withdrawal from a 401(k) plan should be a last resort. It’s a good idea to speak with a financial advisor before doing so.

Sources:

1 https://www.investopedia.com/terms/1/401kplan.asp
2 https://www.investopedia.com/ask/answers/101314/what-are-roth-401k-withdrawal-rules.asp
3, 5, 6, 7 https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-exceptions-to-tax-on-early-distributions
4 https://www.irs.gov/retirement-plans/plan-participant-employee/401k-resource-guide-plan-participants-general-distribution-rules
8 https://www.bankrate.com/investing/sepp-explained/
9, 11 https://www.irs.gov/retirement-plans/retirement-plans-faqs-regarding-hardship-distributions
10 https://www.investopedia.com/articles/personal-finance/072215/401k-rollovers-tax-implications.asp
12 https://www.investopedia.com/ask/answers/09/401k-loan.asp
13 https://www.nerdwallet.com/article/investing/what-is-a-401k