Take a 401(k) Early Withdrawal Without Paying Uncle Sam

By: Clay Wyatt

There are various reasons you may consider taking a 401(k) early withdrawal, meaning prior to attaining age 59 1/2. If you do so, there are potential consequences. The IRS may require you to pay taxes and an additional ten percent penalty on your 401(k) early withdrawal. However, with some careful planning and consideration, you can avoid this fate.

To avoid incurring a 10 percent penalty from the IRS, it is best to get an exception to this penalty. In order to get an exception to this penalty, you must meet at least one of the following criteria:

You become deceased. In this event, your beneficiaries would not have to pay the 10 percent penalty on a 401(k) early withdrawal.
You become disabled.
You take substantially equal distributions over your lifetime. Consult a financial professional if you decide to go this route.
You take a 401(k) early withdrawal to pay for medical expenses that are in excess of 7.5 percent of your adjusted gross income.
You leave your job or retire after age 55.
You are required to take a 401(k) early withdrawal by a divorce decree or separation agreement. This is known as a qualified domestic relations order (QDRO).

If you do not qualify for any of the listed exceptions, then there is another way to avoid being penalized on your 401(k) early withdrawal. You may do so by taking out a loan from your 401(k). This is essentially a loan from yourself that you pay back with interest. The interest goes into your account, so you are not paying that interest to anyone else after you use this method of a 401(k) early withdrawal. It is more like re-saving the money you have loaned to yourself. You may take up to 50 percent or $50,000 out of your account, whichever is less.

Other than the fact that you are not dealing with a lender and do not have to pay an IRS penalty, there are other benefits to taking a 401(k) loan. The money is still tax-deferred as long as it is repaid. While you will lose any gains that the money would have had if it was left in your 401(k) plan, taking this form of 401(k) early withdrawal will not have the risks that a traditional loan will have. Your credit rating will not be impacted. Also, if you are able to get back on your feet financially relatively quickly and have taken a short-term loan, you can pay this money back on time and your savings will not have taken much of a hit (unless the market really went through the roof!). You may even end up better off by having kept some money out of the market during a period of poor performance. While it is not best to count on such a situation, it is a realistic possibility.

As we can see, there are plenty of options for those who wish to take a 401(k) early withdrawal. Knowing how to avoid being penalized for a 401(k) early withdrawal will help minimize your losses in this situation and possibly even work out to a gain. It is best to seek the assistance of a financial professional if you are uncertain whether or not a 401(k) early withdrawal is best for you. Keep in mind that a 10 percent penalty is rarely better than using an alternative source of money for an immediate expense and that it is not a good idea to take a 401(k) early withdrawal for an unnecessary expense, such as a television or Blu-ray player. It is much more important to keep your money in your 401(k) plan for your retirement years so that you have enough to last.