Can You Withdraw from Your 401(k) or IRA Without Penalties?

The Squeeze

• Withdrawing from a 401(k) or IRA before you’re 59½ can result in a big tax bill and penalties.
• A hardship distribution or 401(k) loan may let you tap your retirement funds early without penalty, depending on your financial situation.
• Alternatives like personal loans, payment plans and insurance might be more sound options than a retirement account withdrawal for your long-term financial success.

Retirement plans are awesome.

Money comes out of your paycheck before you see it, someone works some investment magic, and you leave the workforce in your 60s to a glorious, Scrooge McDuck pile of money, enjoying your next 20 or 30 years in a vintage Airstream, motoring along Route 66.

But in the 40 years prior, you’re bound to check that balance once in a while, and that’s when you realize you have 10s or 100s of thousands of dollars. Just sitting there.

Then the college tuition bill arrives, your roof springs a leak and your mom needs to move in after her hip surgery. Now that retirement account takes on a whole new air of possibility.

Could any of the money you’ve saved for your retirement help you save the day for your family? The simple answer is yes, but at a cost that can last a lifetime.

Here’s what you need to know, the costs involved and the options to consider before you tap into your hard-earned retirement funds.

How Do 401(k) and IRA Penalties Work?

The first cost to consider arrives by way of your taxes and the IRS.

When you contribute to your Traditional 401(k) or individual retirement account (IRA), you get to claim the contribution as a tax deduction for the year. So, you don’t pay taxes on the money you stow away for retirement.

In exchange, you agree not to use that money until you retire (or technically, until you’re older).

No matter when you withdraw money from a Traditional retirement account, you pay taxes on it like income. If you withdraw any time before you’re 59½ years old, you’ll also pay an extra tax:  10 percent of the withdrawal amount.

That means you’re best off leaving the money you save for retirement in your account for as long as you can.

But of course, it’s your money, so you can access it whenever you want. The IRS will just charge you its 10 percent penalty as an incentive to let your money stay put and grow so you can enjoy a comfortable retirement as intended.

A Roth IRA or Roth 401(k) — a new employer-sponsored option created in 2001 — is different. You don’t claim a tax deduction for contributions to a Roth account, so you pay taxes on the money up front. You don’t owe taxes when you withdraw — and you won’t owe a penalty for early withdrawal.

EXCEPT…

Retirement accounts are investments, so some of your balance is made up of earnings on your original contribution. If you dip into a Roth account beyond what you contributed and withdraw earnings, those are subject to taxes and early withdrawal penalties.

Reasons to Withdraw from Retirement Savings

Your retirement plan is for retirement. The point is to let your savings sit and grow with interest over many, many years. Pulling the money out now means less money available for your future — a loss compounded by the opportunity cost of interest that your money could have earned.

But we’ve all been there. You might need to tap into your retirement savings to:

• Pay for high medical expenses.
• Pay for college — or preschool.
• Pay for in-home care for your parents.
• Pay for unexpected repairs to your home.

As necessary and stressful as these needs are, you’ll typically be subject to penalties no matter the why that drives you to take money from your retirement account. However, some of these scenarios might make you eligible for what the IRS calls a “hardship distribution,” which could let you tap your funds penalty-free.

How to Withdraw from Retirement Accounts without Penalties

You’ll always pay income taxes on distributions from a Traditional 401(k) or IRA account, but you can avoid the 10 percent extra if you:

• Wait until you’re 59½. This is the main plan. Wait until you’re what the government deems retirement age and you can access funds penalty-free.
• Take a hardship distribution. Your retirement plan might allow hardship distributions, which lets you take money without penalty if you have an “immediate and heavy financial need,” as determined by your plan’s terms. A financial need could be medical expenses, home purchase, education expenses, mortgage or rent payments, funeral expenses, or damage repair due to natural disaster.
• Take a 401(k) loan. Your plan may allow you to borrow up to 50 percent of your account balance in an interest-free loan you can repay within five years. IRA plans don’t allow loans.

If you work for an employer that matches up to a set amount of your 401(k) contribution, put at least that amount into your 401(k) before contributing funds elsewhere. That employer match is free money that should be a priority for most savers.

How to Avoid Early Withdrawals from Your Retirement Savings

Even when you face financial hardship, tapping into your Scrooge McDuck pool might not be your best option.

You don’t have to keep your retirement funds intact at all costs. But weigh your options and do some math — or talk to a financial planner who can do the math for you — to figure out the best way to weather any financial situation while setting yourself up for future success.

Instead of an IRA or 401(k) withdrawal, hardship distribution or loan, consider whether you might be able to get by with:

• A personal loan. You’ll pay interest on this loan. But if you qualify for a low rate, the interest you pay could be less than the earnings you’ll forfeit by taking money out of your retirement investment for years.
• A payment plan. If you’re dealing with medical bills or long overdue debt, you can try to negotiate a payment plan that’ll let you spread the cost over months or years. In many cases, you can even negotiate the balance down.
• Insurance. Premiums for life, health, and home or renters insurance are probably cheaper and give you access to way more money than early 401(k) or IRA withdrawal.
• Student loans. Federal loans for school come with tons of repayment flexibility and forgiveness options that make them fit most financial situations. Your kids can borrow for their education without burdening your current or future financial situation.

Retirement plan withdrawals and loans are one set of tools in your financial arsenal. Think of them as a last resort — and be aware of the costs before you choose this route.