If you're contributing to a 401(k), you probably know it offers tax-advantaged investing and understand that there are many benefits to delaying withdrawals until you're eligible to retire. But to help you deal with life's uncertainties, your plan may allow you to withdraw assets before retirement.
While you may feel an early withdrawal is a harmless way—or the only way—to meet a current financial need, it's important to understand the possible effect on both your retirement account and your overall finances.
When short-term needs arise
You may be considering a 401(k) loan or hardship withdrawal if you need funds for a large immediate expense. Many, but not all, retirement plans offer you a choice between these options.
If your plan allows loans, you may be able to borrow against your vested account balance at a competitive interest rate. You'll repay both principal and interest to your own account. And, if you're borrowing to make a larger down payment on a home, it could help you qualify for a lower mortgage rate and eliminate the need to buy mortgage insurance.
On the other hand, a 401(k) loan will leave you with a lower account balance until it's repaid which will reduce the potential for tax-deferred growth, potentially making it more difficult to prepare for retirement. Other downsides may include:
- Your paycheck will be reduced by automatic loan payments. Not only will this add pressure to your budget, but if it leads you to lower 401(k) contributions, even temporarily, you could find it even more challenging to achieve your goals for retirement.
- The risk of having the loan balance treated as a taxable distribution if you miss payments, default or fail to repay the loan before separating from your employer. In this case, you'll owe federal, and possibly state, income taxes on the distribution in addition to a 10% additional federal tax if you're under age 59½ (see "Tax Implications" below). Repaying the loan as quickly as possible could help you avoid this.
- You'll repay the loan with after-tax dollars, and then you'll be taxed on that money again when you withdraw funds from your 401(k) plan account at retirement.
If you're faced with a financial emergency, you may feel your only choice is to take a hardship withdrawal. You may be allowed to withdraw funds if you have an "immediate and heavy financial need." The plan may require you to prove that you meet its definition of a hardship, such as needing funds to avoid eviction or foreclosure on your primary residence or to pay for certain medical expenses. Keep in mind that the withdrawal will permanently reduce your retirement account balance—hardship withdrawals are not repaid—and could therefore make it more difficult to get back on track. The withdrawal also may trigger taxes and an additional penalty (see "Tax Implications" below). And, you may not be able to make new contributions for a while following the withdrawal.
When change is in the air
Taking an early withdrawal from your 401(k) also can seem like a good idea when you're separating from your employer. But, a career transition is actually an important time to keep your retirement goals on track.1 Making an informed choice about what to do with the balance in your existing 401(k) can help you protect what you've already accumulated and potentially allow your funds to continue benefiting from tax-deferred growth.
Your choices may include:
- Taking a partial or lump-sum distribution. This could be tempting if you need funds to cover current expenses that can't be met with other resources. But, the distribution will reduce your retirement account balance and could trigger taxes, including federal and state income taxes, and a 10% additional federal tax if you're under age 59½. Generally, 20% will be withheld for taxes from your distribution, however additional taxes may be due at tax time.
- Leaving money in your employer's plan.2 If you're satisfied with the plan's investment choices and want to preserve tax deferral, this may be a good choice, at least until you're eligible to enroll in your new employer's plan. But, you won't be able to make additional contributions or take loans and may face service fees and certain restrictions.
- Rolling over assets to a new employer's plan. A direct (trustee to trustee) rollover,3 if allowed by both plans, can prevent a taxable distribution and preserve tax deferral.
- Rolling over to a traditional IRA or converting to a Roth IRA. A direct rollover3 to a traditional IRA also will prevent a taxable distribution and preserve tax deferral. IRAs offer more investment choices and beneficiary options than qualified plans, and may give you access to professional guidance, however, additional fees may apply. With a Roth IRA, you'll owe taxes at the time of conversion, but any future investment earnings may be income-tax free. Roth IRAs don't require distributions and may make it possible to pass assets across multiple generations.
The taxes you may owe when you take a withdrawal will depend on the sort of contributions you've made to your account.
If you withdraw pre-tax contributions and any associated earnings, taxes will be due upon withdrawal. You may also be subject to a 10% additional federal tax if you take a withdrawal before age 59½.
Taxes will not be due on traditional after-tax contributions, but taxes will be due on any earnings. You may also be subject to a 10% additional federal tax if you take a withdrawal of traditional after-tax earnings before age 59½.
Any earnings on Roth 401(k) contributions can generally be withdrawn tax-free if you meet the two requirements for a "qualified distribution": 1) At least five years must have elapsed from the year of your initial contribution, and 2) you must have reached age 59½ or become disabled or deceased. If you take a non-qualified withdrawal of your Roth 401(k) contributions, any Roth 401(k) investment returns are subject to regular income taxes, plus a possible 10% additional federal tax if withdrawn before age 59½.
Merrill Edge and its representatives do not provide tax, accounting or legal advice. Any tax statements contained herein were not intended or written to be used, and cannot be used, for the purpose of avoiding U.S. federal, state or local tax penalties. Please consult your own independent advisor as to any tax, accounting or legal statements made herein.