Why Early Withdrawals Are a Last Resort

Accounts like 401(k)s, Roth IRAs, and traditional IRAs can be excellent and tax-advantaged ways to set money aside for your retirement.

But what happens when you run into unexpected medical bills, need to support a sibling or child, or lose your job? It’s tempting to pull money from retirement accounts, but if you’re under 59 ½, it will likely be costly. 

Let’s take a look at early withdrawals, potential penalties, and some alternative options.

What is an early withdrawal?

If you’re under 59 ½, withdrawing money from a retirement account will usually count as an early withdrawal, but there are some nuances. An early withdrawal from a 401(k) plan, 403(b), 457 plan or a traditional IRA will generally be taxable and subject to a 10% early withdrawal penalty. Money contributed to a Roth IRA account can be withdrawn tax-free, but withdrawing any of the earnings from those contributions will be subject to taxes and the 10% penalty.

How much you’ll pay in taxes will depend on your income bracket; that money will generally be taxed at your ordinary income tax rate.

There are some exceptions to the early withdrawal penalties. Among a few others, they include:

• If the account holder suffers from a permanent and total disability 
• Unreimbursed medical expenses that exceed 7.5% of your adjusted gross income
• Separation from service by an employee at age 55 (age 50 in the case of some public service employees, such as police officers and first responders). This only extends to the employee’s current plan and must be a provision of the plan added by the employer
• A distribution of up to $5,000 per child for qualified birth or adoption expenses
• Distributions after the death of the account owner
• Up to $22,000 to qualified individuals who sustain an economic loss caused by a federally declared natural disaster where they live
• Qualified higher education expenses

Note that a rollover, wherein you transfer your 401(k) account investments to another 401(k) or a traditional IRA when you leave an employer, doesn’t count as an early withdrawal.

Why financial advisors don’t like early withdrawals

An early withdrawal from a 401(k) or similar retirement plan that doesn’t fall into one of the exceptions listed above has a number of downsides.

First, it’s expensive now. A 10% penalty is bad enough; add in the taxes and the highest earners would pay 47% in combined taxes and penalties. Even if your tax bracket is significantly lower, you’re likely looking at paying a third of your withdrawal in taxes. And if you need to pull money from these accounts to cover unanticipated expenses, well, you might not have enough to pay the penalty and taxes without taking more out of your retirement account.

Second, it’s expensive in the future. Anything you withdraw early (including what you withdraw to cover taxes and penalties!) won’t be available during retirement—and neither will any gains you might have earned on that money. It’s a significant step backwards on your retirement savings journey.

What you might do instead

If you need the money, there are some alternatives to withdrawing money from your retirement accounts.

401(k) loans

If your employer’s plan offers loans, this can be a way to get money from your 401(k) plan account without paying taxes or penalties.  A 401(k) loan is exactly what it sounds like: You borrow money from your plan account and pay it back within a specified period of time. 

There are some limits. The maximum amount that you can borrow is the lesser of 50% of your vested account balance in the plan, or $50,000, unless your employer has their own lower limits. This also represents the highest amount of total loans you can have outstanding from the plan at any point in time. An exception to this is if 50% of the vested account balance is less than $10,000, then the plan participant can borrow up to $10,000 if the employer allows for this exception.¹ 

There are no taxes or penalties due on this loan, and the interest that you pay on the loan is paid into your 401(k) account along with your principal payments. Additionally, a 401(k) loan will not impact your credit score should you seek to open a new credit card account, obtain a mortgage, etc. 

It’s not an unalloyed good, however.

• The money that you’ve borrowed from your plan account isn’t invested, and you lose the potential for any investment gains. 
• If you leave your employer before the loan is fully paid back, you’ll need to pay this money back within a time frame specified by your employer.
• If you can’t repay the loan for any reason the amount of the loan outstanding will turn into a distribution. You’ll owe any taxes due plus a 10% penalty if you’re under age 59 ½. 
• Some employers won’t allow you to contribute to the 401(k) account while you have a plan loan outstanding. This means that you’d lose the amount that you would have contributed plus any earnings on those contributions. Additionally you’d lose out on any employer matching contributions plus any appreciation on that money as well.
• Many plans charge fees on the amount of the loan outstanding on a quarterly or other basis. This can drastically increase the cost of your 401(k) loan as well. 

Other sources of cash

If you need cash to cover certain expenses there may be better options than a 401(k) plan loan or an early withdrawal. These can include:²

• If you need to cover qualified medical expenses and you have a Health Savings Account (HSA), you might consider tapping it. An HSA is a high-deductible medical savings account that is designed to cover excess, eligible medical and related expenses, and money can be withdrawn tax-free to cover qualified expenses.
• If you have an emergency savings account, well, this is what those are for. This is your money so there is nothing you will have to repay, but it is a good idea to replenish this account as soon as you can. 
• Using other non-retirement savings and investment accounts such as checking, savings, or brokerage accounts. There will be nothing to repay, and the tax hit should be minimal in many cases. 
• Using a home equity line of credit or a personal loan. In the case of a home equity line of credit, be sure to consult with a financial advisor to understand the impact this will have on your overall financial situation.
• In some cases, it might make sense to tap your contributions to a Roth IRA if you have an urgent need for some cash. Contributions to the account can be withdrawn tax- and penalty-free at any time. Just be sure not to withdraw the earnings from those contributions, as that money would be taxed and subject to any applicable penalties.

Look at all of your options

If you find yourself in need of a cash influx for an unexpected expense, we suggest you do whatever you can to avoid tapping your 401(k) early. Your future self will thank you!