Typically, people who want to know about 401(k) withdrawals are considering tapping their tax-deferred retirement savings early. When folks are retirees and live off their savings, they usually refer to their withdrawals as distributions. The IRS highly regulates all 401(k) distributions, including those that are early, regular and required. Read on for the rules about taking money out of your 401(k), whether you’re younger than 59.5, older than 72, or any age in between. Knowing these rules will help you avoid steep IRS penalties. For more hands-on guidance, consider enlisting the help of a trusted financial advisor.
Rules About Regular 401(k) Withdrawals
Tax-advantaged 401(k) plans are meant to help people save for retirement. You don’t owe taxes on your contributions, your company’s matches if it does them or any earnings until you retire. Once you do hang up your hat, you’ll pay ordinary income tax on your distributions.
Generally, you are eligible to start taking distributions from your 401(k) when you reach 59.5 years. You can also take distributions if you lose your job at age 55 and decide to retire. These are the earliest ages at which you can start receiving monthly or annual installments that draw down your account.
On the other end, the latest point when you can start withdrawing money is 72 years. (Until the passage of the SECURE Act at the end of 2019, the deadline was 70.5 years.) The IRS not only requires that you start taking out money from your 401(k), it specifies how much. This amount is called a “required minimum distribution,” or RMD. It’s the minimum amount you must withdraw, based on your life expectancy.
Rules About 401(k) RMDs
As just noted, the minimum age for RMDs just changed. Before, you had to start taking them either when you retired or when you reached 70.5. This age requirement still holds for anyone who turned 70.5 in 2019 or earlier. Anyone who has not yet turned 70.5 can wait until they are 72.
Technically, you don’t have to take the RMD until the April after you turn 72 (or April 2020 if you turned 70.5 in 2019). The year in which April 1 is your RMD deadline is designated as your “starting year.” After the starting year, the deadline shifts to December 31. So your second year and thereafter, you must take your RMD by December 31.
If you wait until April 1 of your starting year to take your RMD, you will have to take two year’s worth of RMDs the same year. You should avoid this, as it will increase your income for that year, likely putting you in a higher tax bracket. If you fail to take any RMD or you don’t take a large enough RMD, as required by the IRS, you may have to pay a 50% penalty on the money you should have withdrawn.
Find these rules confusing? A financial advisor can help.
Rules About Early 401(k) Withdrawals
Should you make a 401(k) withdrawal before you reach age 59.5, the IRS will consider it an early distribution and impose a 10% tax penalty on it. In addition, because you haven’t yet paid any taxes on the money, you will owe income taxes.
That said, the IRS allows for penalty-free hardship withdrawals. To qualify for one, you’ll need to demonstrate what the IRS calls an “immediate and heavy need.” On top of this, you must prove that there are no other assets that could satisfy that need, such as a vacation home. Examples of hardship that can earn you an exemption from the 10% withdrawal penalty include:
- Funeral expenses
- Medical expenses
- Purchase of a home
- Education expenses
- Housing payments needed to prevent eviction
- Certain home repair expenses for a primary residence
It should be noted, though, that it’s up to your plan to allow for hardship withdrawals. The IRS doesn’t require them. It only delineates the circumstances under which they may happen. Also, you should know that though you won’t have to pay the 10% penalty, you will still have to pay income taxes on the distribution.
Rules About 401(k) Loans
Another option open to employers is to allow 401(k) plan participants to borrow from their 401(k) accounts. You then repay the loan plus interest. Some plans recommend covering the interest by bumping up the pre-tax deferrals from your paycheck.
The good news about 401(k) loans is that they offer lower interest rates and don’t require a credit check, unlike many other loans. The bad news is that if you leave your company voluntarily or involuntarily, the loan becomes due typically within 90 days, depending on your terms. If you can’t repay the funds you’ve borrowed within that time frame, the IRS treats the money as income, taxes it as such and levies the 10% early withdrawal penalty.
While 401(k) loans that you repay on time don’t come with the 10% IRS penalty, they do – again- come with interest. Also, many companies won’t allow you to contribute to your 401(k) while the loan is outstanding. Because of this, you lose the chance to contribute and take advantage of compound interest.
A 401(k) helps your retirement savings grow by acting as a tax shelter. When you take early withdrawals, which is before age 59.5, the tax protection on that money disappears. You’ll also be hit with a 10% penalty. On the other side of 59.5, you must begin to take distributions by age 72 (or 70.5 if you turned that age by 2019), if you haven’t already begun. The penalty for not doing so is 50% of the money should have withdrawn.
Tips for Planning Your Retirement
- Switching from saving for retirement to spending your nest egg is a tough transition. A financial advisor can help you figure out which accounts to draw down first, when to start taking Social Security and more. To find the right one for you, use SmartAsset’s matching tool. It is free and takes five minutes.
- If the idea of a protected stream of income that you can’t outlive sounds good, you may want to look into buying an annuity. These insurance products are pretty complicated though – and there’s a wide variety and selection. In other words, you’ll want to do your homework. You can start by reading up on the pros and cons.
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