A 401(k) is one of the most powerful retirement savings tools available to American workers today. However, there comes a point in your life when you may want to stop making contributions and start taking distributions from your 401(k). Is this possible? When can you withdraw from your 401(k)?
Here's how to navigate the rules that govern when and how you are allowed to make a withdrawal from a 401(k).
What Is a 401(k)?
A 401(k) is a retirement plan made available to employees by their employers. It's named after section 401 of the Internal Revenue Code, which provides rules on qualified employer plans for pensions, profit-sharing and stock bonus funds.
A 401(k) can come in the form of either traditional or Roth accounts; the difference lies in how they're taxed when you go to withdraw money during retirement.
What Is a Traditional 401(k)?
A traditional 401(k) is a retirement account that employees contribute to out of their paychecks. The money gets the benefit of pretax savings — to put it another way, using a traditional 401(k) means that you save on taxes now, but you'll have to pay them later when you make a withdrawal in retirement. This reduces your taxable income, potentially moving you into a lower tax bracket.
Additionally, many employers match contributions from employees up to certain percentage limits. This matching contribution adds an additional benefit for those participating in a traditional 401(k). Employer matching is essentially free money; if your employer offers it to you as a work benefit, consider taking them up on the offer.
What Is a Roth 401(k)?
A Roth 401(k) is an employer-sponsored retirement savings plan that allows employees to save on a post-tax basis for their retirement.
With Roth contributions, you pay the tax up front — but afterward, you won't be taxed for distributions in retirement. Because you'll be making contributions with after-tax dollars, withdrawals from your account during retirement can be 100% tax free if certain conditions apply.
A Roth 401(k) can make things easier if you expect to be in a higher tax bracket down the road when distributions occur.
When Can You Withdraw From Your 401(k)?
You can withdraw money from your 401(k) at any time. However, withdrawing from either your traditional or Roth 401(k) before you turn 59 and a half will typically result in a 10% penalty.
Some people withdraw money in the form of a 401(k) loan, where you essentially borrow money from yourself. However, there are negatives to doing this. Taking money out of your 401(k) could impact future earnings possibilities. Additionally, if you get fired from your job, the loan balance could be due sooner than expected.
How Can You Avoid a Penalty When Withdrawing?
If you want to make a withdrawal from your 401(k) without penalty, you'll typically have to wait until age 59 and a half.
However, in certain cases, it may be possible to avoid the penalty fee. For example, section 2202 of the CARES Act made it possible to withdraw money without a penalty during the COVID-19 pandemic. You can also withdraw money early if you meet other criteria, such as becoming totally disabled.
Additionally, a guideline called the Rule of 55 allows you to withdraw from your current 401(k) without consequences — but only if you've reached age 55 or older and leave your job by retiring or being laid off.
Is Withdrawing Money From a 401(k) a Good Idea?
Many factors that go into the decision to pull money from your retirement account before retirement age. It can provide a temporary financial boost in the short term; people most commonly withdraw money early after losing their job or having some other emergency where they need access to cash. However, you will likely have to pay taxes on the withdrawal, and any penalties could be high as well.
In order to help ensure your retirement money remains intact, aim to keep your 401(k) full and make a smart investment in your future self.