- Contributions to 401(k)s are tax-deferred.
- Distributions are taxed as income when they are taken.
- Withdrawals before the age of 59 1/2 may incur an early withdrawal penalty.
- After account holder turns 70 1/2, required minimum distributions must be taken.
When you save for your retirement with an employer-sponsored 401(k), you typically plan to grow your investment over time. However, unexpected circumstances can occur, and there are situations where you might need to take an early distribution before you retire. Having a strong understanding of 401(k) withdrawal guidelines, especially in terms of when distributions are permitted, when distributions are required, and potential penalties, is an important part of having a good handle on your retirement savings.
Taking a Penalty-Free 401(k) Withdrawal
Funds contributed to a 401(k) are tax-deferred, so you can expect to pay regular income taxes on any 401(k) distribution that you take. There are certain situations that are considered regular distributions. In these cases, the standard taxes are the only amount you will pay as a result of withdrawing funds from your account.
The 401(k) withdrawal age is 59 1/2. Once you reach that age, you no longer have to worry about 401(k) early withdrawal penalties, no matter the circumstances of the withdrawal. There are two additional situations in which your funds can also be withdrawn without penalty – if you become disabled or if your beneficiaries take distributions after your death.
401(k) Withdrawals to Rollover or Transfer Your Account
Other situations may arise in which you need to take a distribution before you turn 59½. For example, your employer may discontinue the 401(k) plan or you could leave your job. In these circumstances, you have the option to rollover or transfer the funds to another qualified plan, such as a Rollover IRA. Once funds move to an IRA, rules applicable to the IRA will apply to any future distributions.
If you choose a rollover option, you may not incur taxes or penalties. However, strict regulations apply to rollovers. If you do not meet the requirements, you can find yourself responsible for taxes and an early withdrawal penalty.
401(k) Withdrawals That May Incur a Penalty
Unfortunately, unexpected and emergency expenses are a part of life, and you may experience a financial hardship that requires you to dip into your retirement savings. Many plans permit a 401(k) hardship withdrawal under limited circumstances, such as:
- Higher education expenses
- Uninsured medical expenses
- Preventing eviction or foreclosure
- Purchase of a primary residence
- Funeral expenses
- Certain repairs due to damage of your primary residence
In most cases, you will not be permitted to make a hardship withdrawal unless one of the above situations apply, and most plans will request documentation of the hardship before permitting the distribution. When you take a hardship withdrawal, income taxes and a 10% tax penalty are assessed. Note that your employer has the option of requiring your spouse’s acknowledgment and agreement before you take a withdrawal from your 401(k) account.
Required Minimum Distributions
Because your 401(k) contributions are tax-deferred, you do not pay taxes on funds in the year that you make your contribution. However, IRS regulations are in place to ensure that you pay taxes on this income at some point. Regulations state that employees must take required minimum distributions (RMD) by April 1 of the year after they reach age 70 1/2, unless they are still employed. However, your employer can choose a plan design that requires minimum distributions at age 70 ½ regardless of your employment status. Business owners who have 5% or more of ownership shares of the company must begin taking the RMD at age 70½, even if they are still working. Failure to take your RMD will result in a 50% tax penalty on the amount that should have been distributed.
Required minimum distributions are calculated based on your life expectancy and, in some cases, on the joint life expectancy of you and your beneficiary. Fortunately, your plan administrator is responsible for calculating the amount of your RMD. The IRS offers additional information and worksheets for those that wish to calculate their RMD independently.
Nothing in this article should be construed as tax advice, a solicitation or offer, or recommendation, to buy or sell any security. This article is not intended as investment advice, and Wealthfront does not represent in any manner that the circumstances described herein will result in any particular outcome. Financial advisory services are only provided to investors who become Wealthfront clients.
This article is not intended as tax advice, and Wealthfront does not represent in any manner that the outcomes described herein will result in any particular tax consequence. Prospective investors should confer with their personal tax advisors regarding the tax consequences based on their particular circumstances. Wealthfront assumes no responsibility for the tax consequences to any investor of any transaction. Investors and their personal tax advisors are responsible for how the transactions in an account are reported to the IRS or any other taxing authority.