Being aware of the 401K withdrawal rules can save you from making costly mistakes. A 401K withdrawal is different from a 401K loan, which has its own set of rules and restrictions. There are four main types of 401K withdrawals:
- 401K Hardship Withdrawals
- Penalty-Free 401K Withdrawals
- Required Minimum Distributions
- 401K Distributions in Retirement
Here are the rules for each of these four kinds of 401K withdrawals:
1. 401K Hardship Withdrawal Rules
In order to discourage you from taking early withdrawals from your 401K plan, the IRS imposes a 10% early withdrawal penalty if you are younger than 59-1/2. You may take a hardship withdrawal (if your employer permits it) to cover certain expenses, such as:
- Medical expenses incurred by you, your spouse, or your dependents
- Costs related to the purchase of your principal residence (excluding mortgage payments)
- College tuition and related educational fees and room and board for the next 12 months for you, your spouse, children and dependents
- Costs necessary to prevent being evicted from your home or foreclosure on your principal residence
- Funeral expenses
- Some expenses for repairing damage to your principal residence
In order to qualify to take a 401K hardship withdrawal, you’ll need to show your employer financial proof that you need to take money out of your 401K. The alternative is to “self-certify,” which doesn’t require you to disclose your finances. However, you won’t be able to make new 401K contributions for six months after taking the withdrawal. Contact your human resources or personnel department to see if they allow hardship withdrawals and what you must do to qualify.
2. Penalty-Free 401K Withdrawal Rules
A penalty-free withdrawal allows you to withdraw money before age 59-1/2 without paying a 10% penalty. It does not, however, mean tax-free. You will still have to pay taxes at ordinary income-tax rates. You may qualify to take a penalty-free withdrawal if you take a distribution before age 59-1/2 and meet any of these situations:
- You have a qualifying disability
- For medical expenses up to the amount allowable as a medical expense deduction
- You are required by court order to give the money to your divorced spouse, a child or dependent
- You’ve experienced a disaster which has been granted relief by the IRS
- If you’ve left the company and have set up a schedule to withdraw equal periodic payments for at least five years, or until you reach age 59-1/2, whichever is longer
Again, check with your company’s human resources or personnel department to learn if these withdrawals are allowed by your employer and how to apply for them. (There is also one exception to this rule allowing penalty-free withdrawals at an earlier age.)
3. Required Minimum Distributions (RMD’s)
Once you turn age 72, you are required to start taking 401K withdrawals whether you need or want to or not. After all, the IRS let you defer paying taxes on your contributions and growth, but there is a limit to the government’s generosity. They need to collect the revenue you owe them for all those taxes they let you defer all those years!
These required distributions are calculated based on your life expectancy, so you receive the entire balance of your 401K during your life expectancy. Penalties apply if you miss taking an RMD or take the wrong amount. Your plan administrator must determine the minimum amount required to be distributed to you each year. Check out the IRS’s rules for Required Minimum Distributions (RMDs) to help you figure your required minimum distribution.
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4. Taking 401K Distributions in Retirement
Once you are older than 59-1/2 and are ready to take withdrawals, you typically can take a lump-sum distribution or periodic distributions. A lump-sum distribution may give you a big chunk of cash right away, but you’ll pay income taxes on the entire amount right away. That can take a big bite out of your nest-egg all at once. If you wish to keep your money in your 401K plan (and your company allows that), you can typically select an amount to receive monthly or quarterly. You’re allowed to change that amount once a year, although some plans allow you to make changes more frequently. The key, of course, is to manage your distributions so you don’t outlive your money.
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