How to withdraw from your traditional 401(k) account early — the strategies to avoid penalties and fees

401k withdrawal

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When it comes to retiring, conventional wisdom says you should wait until age 59½ to take money out of your 401(k) plan. But what if you need cash before then? 

The good news: You can access your 401(k) funds sooner, a process the IRS calls an “early withdrawal.” The bad news: If you do, you usually trigger taxes and a steep penalty — and lose out on years of potential growth for your nest egg. 

However, there are exceptions to the rules — and strategies to avoid such dire consequences.

Consequences of a 401(k) early withdrawal 

A 401(k) is an employer-sponsored retirement plan. You make regular pre-tax contributions to it – that is, straight off the top of your paycheck — and the money within it grows tax-free.

Because these tax-advantaged accounts are meant to help you save for retirement, the IRS imposes strict rules about when and how you can withdraw your money. Primarily, that you have to be at least 59 years and six months old. 

Technically, anyone can withdraw funds at any time — or take a distribution, in IRS-speak — from their 401(k) before they hit that magic age. It’s your money, after all.

But you may not get as much money as you had hoped for. That’s because the withdrawal will be subject to:

A mandatory 20% federal tax: When you take out money, the plan’s service provider is required to withhold 20% in federal income tax. That means if you withdraw $10,000, you will get $8,000.

A 10% tax penalty: You will owe a 10% penalty when you file your income tax return — or $1,000 on that $10,000 withdrawal. 

Taxes and penalties aren’t the only things to worry about when you tap your 401(k) early. Something that could be even worse — in the long run, at least — is the missed opportunity for that money to grow in your account.

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For example, say you withdraw $20,000 when you’re 40 years old. Assuming a 7% annual rate of return, the potential future value of that $20,000 today would be about $110,000 by the time you retire at age 65.

Exceptions to the 401(k) early withdrawal tax penalty 

In most cases, you can’t get out of paying taxes on the money you withdraw from a 401(k). But people in some situations can avoid the 10% penalty. The IRS will consider waiving the penalty if any of the following situations apply:

You become or are permanently disabled: If you are or become disabled for life, you won’t owe the penalty.

You are dividing assets in a divorce: Withdrawals made to satisfy a court order to divvy up the 401(k) with a former spouse or dependent are penalty-exempt.

You are a qualified military reservist: You can take penalty-free withdrawals during your service period if you’re called to active duty for at least 180 days. 

You leave your job at age 55: Also known as the Rule of 55, this provision allows anyone who retires, quits, or is fired at age 55 to withdraw without penalty. 

You enroll in “substantially equal …read more

Source:: Business Insider


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