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401(k) withdrawal rules: What to know before cashing out — and how to avoid penalties

Melanie Lockert
Updated
401(k) withdrawals: Rules you should know before cashing out — and how to avoid penalties (Ariel Skelley via Getty Images)

Your retirement account is a reflection of your hard work over the years. And as you get closer to retirement age, you may think about tapping some of those funds to cover unexpected costs.

You’re not just imagining that everything is more expensive these days: Consumer expenses have increased by 3.5% over the past year, according to recent Bureau of Labor Statistics (BLS) data. But while accessing the money you’ve amassed can be enticing, 401(k) withdrawal rules state that you must be at least age 59½ for a penalty-free withdrawal — at that point, it’s considered a qualified distribution. If you tap your 401(k) before the age of 59½, you’re subject to a 10% early withdrawal penalty, except under specific circumstances.

Learn the ins and outs of 401(k) withdrawals and potential consequences before making any moves with your retirement money.

The minimum withdrawal age for a traditional 401(k) is technically 59½. That’s the age that unlocks penalty-free withdrawals. You can withdraw money from your 401(k) before 59½, but it’s not advisable — you’ll pay the price for it, literally.

Based on 401(k) withdrawal rules, if you withdraw money from a traditional 401(k) before age 59½, you will face — in addition to the standard taxes — a 10% early withdrawal penalty. Why? Ideally, those funds are for retirement, and the penalty is one way to discourage people from touching their 401(k)s.

If you plan to hold off on withdrawing from your 401(k) even after you retire, be aware of the required minimum distributions — or RMDs — for a traditional 401(k). RMDs are mandatory distributions on a 401(k) that you must begin taking at age 73, according to the IRS.

So if you’re retired but don’t want to touch your 401(k) money because of tax purposes or to continue growing your nest egg, you have until age 73. At that point, you must start taking the required minimum distribution.

The IRS enforces RMD rules so that the agency can collect tax revenue. You’re only taxed on your 401(k) at the point of withdrawal, so these rules help prevent people from avoiding their tax obligations.

Typically, if you haven’t complied with the RMD rules, you’d face a 50% excise tax on the amount not withdrawn. However, the SECURE 2.0 Act cut that in half to 25%. If you resolve the issue within two years, that percentage may drop down to 10%.

Withdrawal rules differ for a Roth 401(k). A Roth 401(k) is funded with post-tax money, unlike a traditional 401(k) made with pre-tax contributions.

For a Roth 401(k), you can withdraw money without penalty or taxes if you’re at least 59½ and have owned your account for at least five years. Withdrawals from a Roth 401(k) are also allowed without penalty if you become disabled or if you die, after which a beneficiary can make withdrawals.

Roth 401(k)s also aren’t subject to RMDs, thanks to the Secure 2.0 Act passed in 2023.

Only under very specific circumstances can you withdraw from a traditional 401(k) before 59½ without penalty. Some of the exceptions to the 10% early withdrawal tax include:

  • Birth or adoption. You can take out up to $5,000 per child for eligible birth or adoption costs.

  • Disability. To qualify for penalty-free withdrawals, you must be considered totally and permanently disabled.

  • Disaster recovery. If you’re economically affected by a federally declared disaster, you may be eligible to take out up to $22,000 without penalty.

  • Domestic abuse. Victims of domestic abuse may qualify to take out the lesser of $10,000 or 50% of the account without incurring penalties.

  • Domestic relations. Funds can be withdrawn for a qualified domestic relations order, which is a requirement to pay alimony, child support or marital property rights.

  • Emergency personal expense. Once each year, you may qualify for up to $1,000 or your vested account balance over $1,000, whichever is less, if you’re dealing with a family or personal emergency.

  • Medical. You may be able to take out funds for eligible unreimbursed medical costs in excess of 7.5% of your adjusted gross income.

  • Terminal illness. If a physician has certified you have a terminal illness, you qualify for an exception to the 10% penalty.

A Roth 401(k) allows for withdrawals without penalty or taxes if you’re at least 59½ and have had your account for at least five years.

People shy of retirement age by a few years may be able to avoid the penalty as well, thanks to the “rule of 55.”

“Generally speaking, one of the least common known rules is the rule of 55. If a 401(k) plan participant leaves their employer in the year they turn 55 or older and they leave the 401(k) plan assets in the plan, they may be able to access their 401(k) without the 10% tax penalty,” says Jake Falcon, a chartered retirement planning counselor and CEO at Falcon Wealth Advisors.

If your finances are in dire straits, you may be eligible for a hardship distribution from a 401(k). To qualify for a hardship distribution, you must be in “immediate and heavy financial need.” Plus, you may only take out an amount that covers your specific situation.

Examples that may qualify under traditional 401(k) hardship withdrawal rules include:

  • Medical care for you, your spouse, your children or a beneficiary

  • A withdrawal to prevent eviction or foreclosure

  • Funeral expenses for you, your spouse, children or beneficiary

  • Some instances of home repair

  • College tuition, related fees, room and board for one year for you, your spouse, your children or beneficiary

  • Costs incurred from buying a primary residence

Unfortunately, due to disbursement rules on 401(k) accounts, you’ll still pay taxes and likely be hit with the penalty if you’re not 59½ with a hardship distribution. The only way around the penalty is if you meet the requirements for one of the exceptions.

Also, you don’t have to pay back the amount you withdraw from your 401(k). While that may seem like a good thing on the surface, it can shrink your nest egg. Not only are you taking out funds from retirement, but you’re also missing out on time in the market and additional compound interest.

You can request a 401(k) distribution by contacting your plan administrator. They’ll likely give you a form to submit your request.

“Withdrawals can be requested at any time, and you will be taxed upon the distribution, and you will add it to your taxable income for the year,” says Lawrence Sprung, certified financial planner, author of Financial Planning Made Personal and founder of Mitlin Financial. “You will have the opportunity to have taxes withheld at the time of distribution to offset your tax liability for the year. It is advisable that you do withhold in order to assure you are not hit with a huge tax bill at the end of the year.”

The 401(k) distribution can be either:

  • A lump-sum payment

  • Annuity or payments over set intervals

Before making a decision, it’s a good idea to talk over your options with a financial and tax professional who can walk you through the process. A lump-sum payment can be useful but has more tax implications to consider. Plus, you’ll be responsible for managing it carefully during your time in retirement. Set payments over time can provide consistency and may be less risky with fewer tax consequences.

You’ll also want to consider your current health, life expectancy and financial circumstances before making a decision.

With a traditional 401(k), contributions to your retirement account are tax-deferred. In other words, taxes you owe are delayed to a later time — in this case, when you make withdrawals from your 401(k).

When you make contributions to a traditional 401(k), you’re using pre-tax funds. This can lower your taxable income and, in turn, lower your tax liability or what you owe. So basically you save on taxes while you’re funding your 401(k) account and then you’ll have to pay taxes on 401(k) withdrawals.

When you start taking qualified distributions, the amount you take out is taxed as ordinary income. That can mean paying more in taxes. To hold off on paying taxes right away, you can choose to roll over your 401(k) to a traditional IRA within 60 days of distribution. But you won’t be able to avoid taxes forever and will pay taxes on withdrawal from a traditional IRA too.

You can minimize the tax hit if you choose to take your 401(k) withdrawals in installments. And you may be better off taking out the distribution earlier instead of waiting for the required minimum distribution period.

Your best bet is to wait until age 59½ so you aren’t hit with an early withdrawal tax. Early 401(k) withdrawals have important tax implications to consider and, ideally, should be avoided.

“The early withdrawal penalty amounts to an additional 10% federal tax on the distribution. As an example, if you are in the 24% tax bracket and you withdraw funds from your 401(k) early, you should expect to owe approximately 34% — 24% tax bracket plus 10% penalty — on the withdrawal,” says Sprung.

Your 401(k) is your money, but you’ll want to be smart about your 401(k) withdrawals. Before choosing to take a distribution, consider:

  • Your age. Are you 59½? If not, be ready for the 10% penalty and taxes.

  • Tax situation. Whatever your age, it’s a good idea to talk to a professional about tax planning before a 401(k) distribution.

  • Financial circumstances. Consider if you want a withdrawal at 59½ or by age 73, when there are mandatory distributions on your 401(k). If you’re younger than 59½, see if you can qualify for an exception.

  • Impact. For early 401(k) withdrawals, consider the impact on your nest egg over time. How will this affect your investments, and what earnings will you be missing out on?

If you haven’t hit the minimum age requirement of 59½ and want to take an early 401(k) withdrawal, first weigh these alternatives against the potential consequences of withdrawing early.

  • 0% APR credit card. A 0% APR balance transfer card can help you cover expenses with no interest over a promotional period of 12 months or longer, depending on your credit — without you raiding your 401(k). Just be sure to prioritize paying off your balance before the promotional period ends.

  • Personal loans. Most credit unions, banks and online lenders offer flexible personal loans that don’t require collateral — or touching your 401(k) — at rates that beat credit cards.

  • Home equity. If you own a home, look into a home equity loan or line of credit. But proceed with caution: Anytime you borrow against your equity, you’re using your house as collateral for the loan — which means if you’re not able to repay what you borrow, you risk losing your home.

  • Payment plans. If you have medical expenses, see if you can negotiate with your medical provider or qualify for payment plans to help make repayments more manageable.

A 401(k) loan is a type of loan that allows active employees to borrow from a retirement account balance, making you both the lender and the borrower. Not all retirement plans allow for 401(k) loans, but if yours does, you could be eligible for a loan of up to 50% of your vested balance or $50,000, whichever is highest.

With a 401(k) loan, you can generally avoid the taxes and penalties that come with an early withdrawal, and you’re typically given five years to repay what you borrow. It means that, depending on the interest rate you’re offered, a 401(k) loan could be a better option than, say, a payday or high-interest personal loan.

But 401(k) loans come with risks that can affect your ability to retire on time, providing room to pause, including:

  • Loss of investable growth. When you borrow from your future retirement funds, you’re missing out on time in the market and compounding interest while you pay it back. You’re also repaying the loan with post-tax dollars that you’ll pay tax on again in retirement.

  • Stiff tax penalties if you default. If you find yourself unable to repay your loan and accrued interest as agreed to, the loan is considered an early distribution, triggering the 10% early withdrawal penalty and any taxes.

  • Accelerated repayment if you leave your job. If you leave your employer or if you’re laid off before you’ve repaid your loan, you’ll need to pay the outstanding balance in full more quickly or the loan becomes a nonqualified distribution, leaving you on the hook for a 10% early withdrawal penalty and taxes.

Consider a 401(k) loan only after you’ve exhausted all other options. And if you decide to take on a 401(k) loan, prioritize paying off what you borrow as quickly as possible so that you can get back to contributing toward your retirement, taking advantage of any company matches and leveraging valuable compound interest.

Learn more about 401(k) withdrawals and distribution rules when weighing your options.

A minimum required distribution is the amount you’re required to withdraw from your traditional 401(k) starting at age 72, with a few exceptions for business owners. If you fail to withdraw the full RMD each year by your due date, you face stiff penalties that include a 50% excise tax on the amount not withdrawn — though you can correct the problem and pay 10% tax if it’s fixed within two years.

Roth 401(k)s are excluded from RMDs, thanks to the Secure 2.0 Act passed in January 2023. With this 401(k), you can withdraw money without penalty or taxes if you’re at least 59½ and have owned your account for at least five years.

If you’re the beneficiary of a 401(k), when you’re required to withdraw funds from the account depends on your relationship to the original owner, the circumstances of the owner’s death, your current age and other factors. Generally, distribution options include a lump-sum payment, rolling the account into your own 401(k) or IRA or doing nothing, though you could face substantial taxes, depending on which option you choose.

Before you make a decision, speak with an expert who understands inherited 401(k)s — like a financial advisor, a tax specialist or an inheritance lawyer — to make sure you’re positioned for the best outcome you’re eligible for.

Compound interest is often described as earning interest on your interest. It’s a powerful way to boost your savings over time by earning interest on both your initial contributions and any interest you earn along the way, leading to exponential growth over time.

Say you invest $100 into an account that pays 10% interest. After one year, you’d have earned $10 in interest — for a total of $110 in your account. If you didn’t touch your account for another year, you’d have earned $11 in interest — $10 on your initial deposit and another $1 on the interest you earned in year one — for a new total of $121. Year three, you’d earn $12.10 in interest — $10 on your initial deposit and another $2.10 on the interest you earned. And so on, and so on, even without additional contributions to that initial $100.

Thanks to compounding, the earlier in your working life that you can begin contributing toward your retirement, the more time your money has to compound — and the more your money can grow than if you’d contributed later in your life.

No. The federal Employee Retirement Income Security Act of 1974 — or ERISA — prevents creditors from making claims against funds in retirement accounts like 401(k)s, protecting the money you paid into your account, even if you declare bankruptcy.

ERISA also protects you against mistakes your employer or plan administrators might make that affect your retirement account, including incorrect balances and late transfer of your contributions.

Melanie Lockert is an L.A.-born and Brooklyn-based freelance writer with a decade of experience in personal finance. Melanie started the Dear Debt blog in 2013 and chronicled her journey out of $81,000 in student loan debt. She published a book of the same name in 2016. Her personal finance expertise has been featured on Fortune Recommends, CNN Underscored, Yahoo Finance and Business Insider, among other publications. She is also the host of the Mental Health and Wealth Show and cofounder of the Lola Retreat, a finance event for women.

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