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How You Can Deal with Emergencies With Your 401(k) Account

As your 401(k) retirement account grows in value over the years, it could be tempting to lay your hands on this hard-earned savings in very exceptional circumstances. Many find it difficult to consider their own retirement savings as being totally off limits, particularly if more immediate needs and wants arise.

Suppose you require a down payment for a new house, college tuition for your kids, or even cash for an unexpected financial emergency, proceed very, very carefully if you are considering a 401(k) withdrawal. Every 401(k) withdrawal has consequences such as sacrificing important benefits of your hard-earned previous plan contributions and can even lead to higher income taxes and additional penalties.

401(k) Account Withdrawal Rules and Penalties

One extremely helpful benefit of a 401(k) plan is that every single contribution allows tax benefits. Not only is your contribution tax-deductible today, but your contributions to your account are also growing at tax-deferred rates. Such tax benefits are applicable if you abide by the plan rules, and these rules set limits on everything from amounts you can contribute annually to when you could withdraw plan funds, without penalties.

With rare exceptions, all traditional 401(k) withdrawals are taxable as ordinary income, although Roth 401(k) assets are treated differently. In an ideal situation, you must not withdraw funds from your 401(k) until after retirement. You pay income tax on each withdrawal as you did with every paycheck earned when employed. But many people find themselves in a lower tax bracket upon retirement than during their working years, and could add some relative tax savings. But if you withdraw funds from your 401(k) before reaching 59.5 age, you will owe income tax on the amount withdrawn, and these funds are also levied an additional 10 percent early distribution penalty tax. This is where things get sticky very fast as for some, this could reduce the amount withdrawn almost in half after paying taxes and penalties! Losing that money to taxes today hurts but will cost you after retirement, even more.

Exceptions to 401(k) Withdrawal Penalties

However there exist several exceptionsto the 10 percent early distribution penalty, intended to alleviate financial losses in certain situations. Under the following circumstances, 401(k) withdrawals resorted to before you reach age 59.5, are exempt from additional penalty:

  • You die and the account is duly paid to your beneficiary
  • You become disabled
  • You terminate employment and are over 55-years-old
  • You withdraw amounts less than those allowed, as a medical expense deduction
  • You begin substantial equal periodic payments (as per Rule 72(t))
  • Your withdrawal is caused by a qualified domestic relations order

Withdrawals under each of these scenarios would only be subject to ordinary income taxes, without the additional 10 percent penalty, but the withdrawals must be according to plan rules and with appropriate documentation. Do educate yourself about plan requirements before resorting to any funds withdrawal.

Additional 401(k) Early Withdrawal Considerations

In addition to taxes and penalties due for a 401(k) early withdrawal, you lose potential future investment growth of the retirement plan funds. There are annual caps to the funds you can contribute to a 401K plan, and you can’t make up for previous withdrawals, later. It would be very difficult to save enough to match the lost earnings and compound interest. Though 401(k) loans have some inherent significant drawbacks, you could consider such a loan if you are in a tight financial pinch and your only way out is by tapping your retirement funds. Even with its drawbacks, a 401(k) loan is always preferable to an outright 401K withdrawal, although neither is actually ideal.

Delaying 401(k) Withdrawals and RMDs

However, people can delay receiving distributions from their 401(k) plans and maximize tax-deferred growth benefits until April 1 of the year following the year when they exceed an age of 70.5 years. Thereafter, you need to plan for withdrawing the required minimum distribution (RMD) annually. Your RMD is calculated as per your 401(k) account balance as at the beginning of the year in question, divided by your life expectancy as per the IRS in their Uniform Life Expectancy Chart. An exception however exists, if the sole beneficiary is your spouse and she is more than ten years younger than you.

Akin to early withdrawals, not utilising your annual RMD earns a steep penalty which is 50 percent of the difference between what should have been distributed and what was actually withdrawn.

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