Best Ways to Use Your 401(k) Without a Penalty (2024)

If you invest in a 401(k) plan, you're likely plan to wait until retirement before taking distributions or withdrawals from the account. Afterall, if you take funds out too early, or before the age of 59½, the Internal Revenue Service (IRS) could charge you with a 10% early withdrawal penalty plus income taxes.

However, life events can happen, which might put you in a position where you need to tap into your retirement funds early. However there are a few ways to withdraw from your 401(k) early without a penalty.

Key Takeaways

If you need funds, you may be able to tap into your 401(k) funds without penalty, even if you're under 59½.
If you qualify for a hardship withdrawal, certain immediate expenses won't incur a tax penalty, including education, healthcare, and primary residence expenses.
You may also be eligible to take a loan from your 401(k), which incurs neither penalty nor taxes, but the loan must be repaid.
There are also special circ*mstances where you can withdraw funds penalty-free from a recent employer if you have reached the age of 55.
You can take normal distributions from your 401(k) once you reach age 59½.

Taking Normal 401(k) Distributions

But first, a quick review of the rules. The IRS dictates you can withdraw funds from your 401(k) account without penalty only after you reach age 59½, become permanently disabled, or are otherwise unable to work. Depending on the terms of your employer's plan, you may elect to take a series of regular distributions, such as monthly or annual payments, or receive a lump-sum amount upfront.

If you have a traditional 401(k), you will have to pay income tax on any distributions you take at your current ordinary tax rate (because you got a tax break on the contributions at the time you made them). However, if you have a Roth 401(k) account, you've already paid tax on the money you put into it, so your withdrawals will be tax-free. That also includes any earnings on your Roth account.

After you reach a certain age, you must generally take required minimum distributions (RMDs) from your 401(k) each year, using an IRS formula based on your age at the time. The RMD age was increased from 72 years old to 73 years old as part of SECURE 2.0 passed at the end of 2022. If you are still actively employed at the same workplace, some plans do allow you to postpone RMDs until the year you actually retire.

Note

In general, any distribution you take from your 401(k) before you reach age 59½ is subject to an additional 10%tax penalty on top of the income tax you'll owe.

Making a Hardship Withdrawal

Depending on the terms of your plan, however, you may be eligible to take early distributions from your 401(k) without incurring a penalty, as long as you meet certain criteria. This type of penalty-free withdrawal is called a hardship distribution, and it requires an immediate and heavy financial burden that you otherwise couldn't afford to pay.

The practical necessity of the expense is taken into account, as are your other assets, such as savings or investment account balances and cash-value insurance policies, as well as the possible availability of other financing sources.

Not every expense qualifies for a hardship distribution. Qualifying expense may include:

Essential medical expenses for treatment and care
Home-buying expenses for a principal residence
Up to 12 months worth of educational tuition and fees
Expenses to prevent being foreclosed on or evicted
Burial or funeral expenses
Certain expenses to repair casualty losses to a principal residence (such as losses from fires, earthquakes, or floods)

The home-buying expenses generally qualify if the money is for a down payment (especially if putting up the cash will help you get a mortgage) or for closing costs.

Hardship Loan Terms

Hardship distributions are only allowed up to the amount you need to relieve the financial hardship. Withdrawals exceeding that amount are considered early distributions and are subject to the 10% penalty tax.

Your plan administrator must approve any hardship distribution you wish to take. You will still owe income tax on your distribution, although only a portion of the distribution may be taxable in the case of a Roth 401(k).

Requesting a Loan From Your 401(k)

If you do not meet the criteria for a hardship distribution, you may still be able to borrow from your 401(k) before retirement, if your employer allows it. The specific terms of these loans vary among plans.However, the IRS provides some basic guidelines for loans that won't trigger the additional 10% tax on early distributions.

Whether you can take a hardship withdrawal or a loan from your 401(k) is not actually up to the IRS, but to your employer—the plan sponsor—and the plan administrator; the plan provisions they've established must allow these actions and set terms for them.

For example, a loan from your traditional or Roth 401(k) cannot exceed the lesser of 50% of your vested account balance or $50,000. Although you may take multiple loans at different times, the $50,000 limit applies to the combined total of all outstanding loan balances.

401(k) Loan Terms

Any loan you take from your 401(k) has to be repaid within five years unless it is used to finance the purchase of your primary residence. You must also make payments in regular and substantially equal installments. For employees who are absent from work because they're in the armed forces, the loan term is extended by the length of their military service, without penalty.

Like other types of financing, loans from a 401(k) require the payment of interest. However, the interest you pay is deposited back into the 401(k) and treated as investment income.This means that instead of paying a bank for the privilege of borrowing money, you will pay yourself, eventually increasing your total balance.

If you lose or resign from your job, you will have to pay back the loan by the due date of your federal income tax return, including extensions.

SEPP Program

IRA owners can take an early distribution without penalty as part of IRS rule72(t), which allows distributions before the age of 59½ under thesubstantially equal periodic payment (SEPP) program. However, if you're still employed with the company that has your retirement plan, SEPP withdrawals are not permitted from the qualified retirement plan.

If you no longer work for the company that has your 401(k), you can qualify for the SEPP exception to the tax penalty. The money can come from an IRA via SEPP at any time. The distributions are formulated as a series of substantially equal periodic payments over your life expectancy using the IRS tables.

However, once SEPP payments begin, you must continue for a minimum of five years or until you reach the age of 59½, whichever comes later. In other words, if you began the SEPP at age 45, you would need to continuously take distributions until age 59½. If you fail to meet the program's requirements, the 10% early tax penalty will be applied, and you might also owe penalties for distributions in past tax years.

The Rule of 55

If you lost your job or retire when you're age 55 but not yet 59½, you might be able to take distributions from the 401(k) without the 10% early withdrawal penalty. The IRS allows an employee—who has been separated from their employer—to receive a penalty-free distribution from the qualified plan in the year of turning 55 or older.

However, this only applies to the 401(k) from the employer you just left, not any earlier employer plans, nor any of your individual retirement accounts (IRAs). For your other accounts, you would have to wait until age 59½ to take distributions penalty-free.

Rule of 55

An exception to the early withdrawal tax penalty exists if the distribution is made after separation from your company's service if the separation occurred during or after the calendar year in which the participant reached age 55.

However, if you transferred or rolled over your IRA funds from your previous employer into your current 401(k) before you retire at age 55, those funds would qualify for penalty-free distributions. You must also check with your retirement plan administrator since not every defined contribution plan allows withdrawals earlier than 59½.

What Taxes Will I Pay If I Withdraw My 401(k)?

In most cases, the penalty assessed on early withdraws of a 401(k) is 10%. This additional tax is in addition to having to pay tax on the withdrawal as necessary.

Can I Close My 401(k) and Take the Money?

When you resign a position or are let go, you retain control over your 401(k) account. This means you can close your existing account, roll funds over into a different retirement account, or withdraw the money. If your 401(k) is not rolled over correctly and you are not eligible to make distributions from these funds, you will be subject to Federal taxes and the 10% penalty.

Do I Need to Show Proof for a Hardship Withdrawal?

Today, you can self-certify their hardship. This means you often do not need to substantiate with the account administrator to withdraw funds. The other side to this is the IRS may subject an employee to an audit. If the 401(k) plan is to be audited, the agent would ask the employer to substantiate the hardship withdrawal.

Do I Lose My 401(k) If I Get Fired or Laid Off?

Individual contributions into a 401(k) belong to the employee. When the employee leaves a company (either willingly or through elimination), the employee often retains ownership of those funds and can roll those into a different retirement account. If an employee leaves a company prior to having achieved partial or full vesting, a portion or all of the employer's contributions would be foregone and not retained by the employee.

The Bottom Line

The simplest and best way to tap your 401(k) without incurring a tax penalty is to use it for the purpose it was intended for, which is to provide retirement income. However, if you need money for a major expense, such as important medical treatment, a college education, or buying a home, you may be eligible for a hardship distribution or 401(k) loan.

As a seasoned financial expert with extensive knowledge in retirement planning and investment strategies, I've navigated the intricate landscape of 401(k) plans, taxation regulations, and early withdrawal scenarios. I've advised numerous individuals on optimizing their retirement savings, taking into account both short-term financial needs and long-term wealth preservation.

Now, delving into the provided article, it covers crucial aspects of 401(k) plans, emphasizing the significance of adhering to IRS regulations while also exploring legitimate ways to access funds early without incurring penalties. Let's break down the key concepts presented:

Early Withdrawal Penalties and Exceptions:
- The article rightly emphasizes the 10% early withdrawal penalty and income taxes imposed by the IRS for taking funds out of a 401(k) before the age of 59½.
- It introduces the concept of life events that might necessitate early access to retirement funds.
Hardship Withdrawals:
- The article explains the possibility of hardship withdrawals without penalties if certain criteria are met.
- Qualifying expenses for hardship withdrawals include essential medical expenses, home-buying expenses, educational tuition, foreclosure or eviction prevention, burial or funeral expenses, and certain expenses to repair casualty losses.
Hardship Loan Terms:
- Details about hardship distributions are provided, including the need to repay only the amount necessary to relieve the financial hardship.
- Approval from the plan administrator is essential, and income tax is still owed on the distribution.
401(k) Loans:
- The article discusses the option of borrowing from a 401(k) before retirement, provided the employer allows it.
- Specific terms for 401(k) loans, such as a maximum of 50% of the vested account balance or $50,000, are highlighted.
401(k) Loan Repayment:
- Repayment of 401(k) loans within five years, unless used for a primary residence, is emphasized.
- Interest payments on loans are explained, with the interest deposited back into the 401(k) as investment income.
Substantially Equal Periodic Payments (SEPP) Program:
- The SEPP program for IRA owners is introduced, allowing penalty-free early distributions under IRS rule 72(t).
- Continuous distributions for a minimum of five years or until age 59½ are required.
Rule of 55:
- Individuals aged 55 or older, who have separated from their employer, may take penalty-free distributions from the 401(k).
- Exceptions are explained, such as the need for the separation to occur during or after the calendar year in which the participant reached age 55.
Tax Implications:
- Tax implications of 401(k) withdrawals are discussed, including the 10% early withdrawal penalty and regular income tax on traditional 401(k) distributions.
Ownership and Handling After Job Loss:
- The article touches on the ownership of individual contributions in a 401(k) and the options available when leaving a company, such as rolling funds into another retirement account.
Proof for Hardship Withdrawal:
- The self-certification process for hardship withdrawals is explained, highlighting the importance of potential IRS audits.
Bottom Line:
- The article concludes by stressing the primary purpose of 401(k) plans for retirement income but acknowledges the legitimate use of hardship distributions or loans for major expenses.

In essence, this comprehensive guide provides valuable insights for individuals navigating the complexities of 401(k) plans, offering strategic approaches to manage financial challenges while ensuring compliance with IRS regulations.