Early withdrawals from 401(k) retirement funds cost Americans $6.12 billion in penalties this year, according to a recent Capitalize survey.
A separate Bank of America report said that the number of 401(k) participants accessing their retirement savings early increased 27% since the beginning of this year. These withdrawals are subject to income tax and potentially a 10% early withdrawal fee for workers under 59 ½. The increase in workers tapping their 401(k)s for emergencies comes as they confront stubbornly high inflation that has rapidly eroded their purchasing power.
The most common reason why workers withdraw funds from plans early is because of a job change. A 2023 study showed that 41% of 401(k) account holders withdraw at least some funds from their accounts when changing jobs instead of completing a rollover into an IRA or new 401(k) plan. The same survey showed most of those cashing out withdraw the entirety of their 401(k) balance.
"Unfortunately, taking money out early can hurt how much you save for retirement in the long run," Capitalize said. "This is even more true if you don't have a plan to put the money back. Economists call taking money out before retirement 'leakage.' It's a big reason why many people don't save enough for when they retire."
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The IRS only lets you take money from your 401(k) without taxes and penalties before the age of 59 ½ in a few exceptional cases covered by "hardship distributions."
According to the IRS, the following situations may qualify as an immediate and heavy financial need:
Another option to access retirement savings without incurring the additional 10% penalty is to borrow from it. Some plans allow workers to take out a 401(k) loan and forgo the income taxes and penalty associated with an early withdrawal.
Workers should remember that while they won't incur a 10% early distribution tax on withdrawals made under these circumstances, the withdrawal is still considered part of their taxable income.
Taking out a 401(k) loan could strain your retirement savings if you fail to pay it back under the plan's terms. If high-interest debt is getting in the way of your retirement savings, you could consider paying it down with a personal loan at a lower interest rate. Visit Credible to speak with a personal loan expert and get your questions answered.
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If you want to maximize your retirement savings, you could consider alternatives to tapping your 401(k) plan early that won't incur payment penalties or taxes. Two options you could look at are using a Roth Conversion Ladder or a 72(t) Substantially Equal Periodic Payments (SEPP), according to Capitalize.
Roth IRAs let people over 59½ take out their original contributions and any earnings without paying taxes. The rules also say that contributions can be withdrawn at any age without taxes or penalties. Contributions must be held in the account for at least five years before the amounts can be withdrawn tax and penalty-free, according to Capitalize.
However, rolling over 401(k) funds into traditional IRAs and then converting a portion of the funds each year into a Roth IRA is taxable. Capitalize explained that converting only the bare minimum you will need in the future, each with its own five-year waiting period, creates a "ladder" of conversions.
"After the first five years, you'll have a chunk converted and ready to go every single year," Capitalize said. "When you retire, any earnings and contributions you didn't use are still in the IRA."
The 72(t) Substantially Equal Periodic Payments (SEPP) lets you take money out of your traditional IRA and 401(k) early without penalties, according to Capitalize. The rule states that you must take out about the same amount of money at least once a year for five years or until you're 59½, whichever is longer.
"You won't pay the early withdrawal penalty on these withdrawals, but you usually still have to pay income taxes on them," Capitalize said.
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