How To Cash Out a 401(k) Early

401(k) accounts let you accumulate wealth and lower your tax bill. Consumers can invest in these accounts and let them build up for decades, but penalty-free withdrawals only start when you turn 59 ½ years old. Taking money out before reaching that age can result in penalty payments on top of taxes. But there are some loopholes that let you avoid paying penalties even if you have not reached the minimum age for penalty-free withdrawals. This guide will examine some of the ways you can cash out a 401(k) early.

What Are My Options if I Need To Cash Out a 401(k) Early? 

You can withdraw funds from a 401(k) at any time, but doing so before reaching the minimum age will result in fees. There are a few exceptions, but most early withdrawals result in penalties. You will also have to pay taxes on the distribution because 401(k)s are funded with pre-tax dollars.

If the expense does not qualify for an exception, 401(k) holders can still apply for hardship qualifications or take out a 401(k) loan. Hardship qualifications apply to people in financial distress who need 401(k) funds to cover necessary expenses. A 401(k) loan is money you take out against your 401(k) instead of withdrawing funds from your 401(k).

What Situations Allow for Cashing Out a 401k Early?

The IRS outlines what qualifies for a 401(k) hardship withdrawal. They are only allowed in specific scenarios, such as:

Medical Expenses

Unreimbursed medical expenses can qualify for a hardship withdrawal. These expenses must be related to services performed for the account holder, their spouse, dependents or primary beneficiary.

Purchase of a Primary Residence

You can use funds from a 401(k) to cover the down payment of a primary residence and avoid penalty fees. You cannot use 401(k) funds to make monthly mortgage payments. This loophole only works when you are buying a home instead of keeping up with mortgage payments.

Prevention of Eviction or Foreclosure

If you are on the cusp of an eviction or foreclosure, you can qualify for 401(k) hardship withdrawals. Under this scenario, you wouldn’t have to worry about penalty fees. This hardship only applies to the account holder’s primary residence.

College Education Expenses

College can get expensive in a hurry between tuition costs, room and board and other educational expenses. Funds from a 401(k) can address these costs without resulting in penalty fees. The account holder, their spouse, children or dependents may be eligible for a hardship withdrawal to cover college education expenses.

Funeral Expenses

The burial of someone related to the account holder may qualify for a hardship withdrawal. 

Should You Consider a 401(k) Loan?

If you cannot get a hardship withdrawal, you may have to settle with a 401(k) loan. These loans do not result in penalties, but it’s important to understand how they work before borrowing money against your 401(k). 

Loan Eligibility

Before you reach out to lenders, ask your employer whether its plan allows you to get a 401(k) loan. If your plan is not eligible for a loan, you will have to seek an alternative.

Loan Limits

401(k) loans have limits designed to keep your funds safe and minimize the lender’s risk. A 401k loan is capped at the lesser of $50,000 or 50% of your vested account balance. You should review your plan to see whether it has a lower loan limit.

Repayment Terms

401(k) loans must be repaid within a designated time frame. The lender and borrower go into the loan knowing the terms, and most of these loans get repaid within five years. Lenders may give you an extended repayment period if you use the 401(k) loan proceeds to cover the down payment for your primary residence. The loan’s repayment may become due right away if you leave your job before repaying the balance.

Impact on Contributions

A risk with 401(k) loans is that these financial products can affect your ability to make contributions. Some loans and plans restrict you from making new contributions or receiving employer-matching contributions. Either of these outcomes can negatively impact your ability to save money for retirement.

Interest Rates and Fees

You have to pay interest on a 401(k) loan. While you can find loans with lower interest rates elsewhere, the rates on a 401(k) loan are lower than other types of debt, such as credit card debt. You will also have to pay fees associated with the loan creation process, such as origination and administrative fees. You should look into the fees and interest rates before taking out a 401(k) loan.

Long-Term Impact on Retirement Savings

A 401(k) loan reduces your account’s balance. This gives you less money for retirement, and you also lose out on potential gains from the money allocated to the loan. Consumers should assess their immediate cash needs and the long-term financial impact of withdrawing early before making a decision.

Tips for Cashing Out a 401(k) 

Some people need to cash out of their 401(k) accounts to cover expenses and make important investments. Following these tips can help you get the most out of your money.

Understand the Consequences

Most people think about the consequences of not getting the money they need right away. You incur long-term consequences for cashing out a 401(k) early. A lower retirement savings account gives you less room to play with during your retirement years, and you may have to work a few extra years to catch up. Withdrawing early also means your taxes are in a higher tax bracket because you still have your salary. Sometimes, a cash out is necessary, but it’s important to assess the pros and cons before an early withdrawal.

Avoid Unnecessary Withdrawals

Sometimes, it’s necessary to withdraw from your 401(k), but it’s unnecessary at other times. You should think twice before using your 401(k) funds to make discretionary purchases or cover something nonessential, such as a vacation. You should look for other funding sources, pick up a side hustle or pursue career advancement instead of making unnecessary withdrawals.

Plan for the Future

When you withdraw from a 401(k), you have less money in your retirement account. Consumers need to catch up or compensate by adjusting their retirement goals. Planning for the future can make your retirement smoother and help you take the right course of action if you make an early withdrawal.

Protecting Your Retirement Funds

An early withdrawal lowers your retirement account’s value and results in less compounding. Early withdrawals are not ideal, but it’s your hard-earned money, and early withdrawals can be necessary for certain expenses. It’s best to avoid early withdrawals from your retirement plan, but if you cannot avoid it, come up with a plan to minimize the impact and replenish your retirement funds.

Frequently Asked Questions