Your 401(k) is your retirement plan — but sometimes you just need to use those funds before you retire. If you make a withdrawal, however, you’ll not only reduce your balance, but if you’re not 59.5 or older, you’ll get an extra 10% penalty fee tacked on to your already taxable deduction. Whenever you make a withdrawal from your 401(k) account it will be subject to taxes, so keep that in mind when deciding whether or not to do it.
But certain situations might leave you with no other alternative than to make a withdrawal — things such as losing your job or experiencing some kind of hardship or emergency. If you need some money from your 401(k), there are a few ways you can get your cash without paying penalties that drain your retirement fund even more than a withdrawal. These ways are very specific, so make sure you follow the rules and check for eligibility so you come out as unscathed as possible.
You can borrow against your 401(k)
If you need the funds only for a short amount of time, you’re in luck — you can borrow from your 401(k) and not even pay taxes on the money. As an added bonus, your loan won’t even show up on your credit report.
The first thing you need to do is find out if your employer allows 401(k) loans. Not all do, but the ones who do typically set the terms for the loans. The IRS allows you to borrow the lesser of half your vested balance or $50,000.
When you take a loan out against your 401(k) you actually pay the principle and interest to yourself. The payments come out of your pay on an after-tax basis and the interest rate is generally a couple of points above prime. Typically, loans are for five years or less but you can get one for up to 15 years.
These types of loans are great because they don’t go on your credit report, the paperwork is minimal, the interest rates are usually lower than you’ll find at banks and the interest goes right back you.
There are a few caveats to taking out loans on 401(k)s. You must be currently working for the employer that holds your 401(k), you won’t be compounding interest on a balance as high as before you took out the loan and if you leave your job you will likely have to pay back the loan within 60 to 90 days — or pay a penalty to Uncle Sam.
You can roll over your 401(k)
Another way to borrow short-term from your 401(k) is to roll it over into another IRA account, which you can do once every 12 months. When you roll over an account, the money is due in the new one in 60 days, and during that time you can do whatever you like with the money without worrying about being penalized. Keep in mind that if you do a rollover you must have that money in another account by the time those 60 days are up or the IRS will treat the money like a full distribution and levy the full amount of taxes on it.
Consider Taking a Series of Substantially Equal Payments
It’s important to note that you can begin making withdrawals from your 401(k) without penalty at any age before 59.5 by taking something called a 72t early distribution, which involves taking a series of specified payments annually. The amount of the payments depends on your age and how much you have in your account. Find out more by visiting the IRS website.
If you opt to do this, you must take the payments for five years or until you reach 59.5, whichever is longer. Because you can never take more or less money out than the calculated amount, make sure this is a move that’s right for your overall financial situation.
You Might be Able to Buy a Home or Pat Off Medical Bills Without Penalty
If you’re a first-time home buyer — defined by the IRS as not having had any ownership interest in a house for the past two years — you can take up to $10,000 out of your IRA penalty-free to buy it. And, although you’ll be losing some of your 401(k) savings, you’ll be essentially putting that money into another solid investment, your home.
If your medical bills exceed 7.5% of your adjusted gross income in a year, you can likely pay for them out of your 401(k) without incurring that 10% penalty fee.
You Can Go to School Without Paying a Penalty
If you use your 401(k) money to pay for higher education necessities such as tuition, fees and books, you can make a withdrawal without paying the penalty fee. You can also apply this rule to your spouse, children and grandchildren. Because this particular withdrawal works differently for a variety of retirement plans, this type of withdrawal might fall under the category of “hardship withdrawal,” so make sure that: a) your employer allows for these types of withdrawals; and b) that you won’t have to pay the 10% penalty. Note that often, 401(k) plans hit you with a penalty fee for hardship withdrawals.
If You Pay Support You Might be Able to Avoid a Penalty
If you are ordered by a court to pay support to an ex-spouse or your children and you need money from your 401(k) to do so, the 10% penalty might be waived.
Think Hard Before You Withdraw
Even though you can make withdrawals from your 401(k) in a number of ways and not pay the penalty, it’s still best not to touch your savings until you are retired. Remember that compounding interest is the key to maximizing your 401(k) funds, and you really don’t want to lose that by taking early distributions.
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