When a financial emergency hits, you may find yourself scrambling to get your hands on the money you need. You may consider taking money from your 401(k) for emergencies, but experts strongly advise not to.
If you decide to do this, remember that there are some financial penalties for doing so, and you are robbing yourself of a comfortable retirement. A 401(k) should not be used as a safety net in a financial emergency. It should be an account that helps you save for retirement.
Here’s what you can do to prepare for financial emergencies instead.
Can You Withdraw Money From a 401(k) Early?
In most cases, the IRS requires you to be at least 59½ to withdraw money from your 401(k) plan. After all, the funds in that account are designed to support you during your retirement years. If you decide to withdraw money early, prepare to see hefty punishments.
Penalties of a 401(k) Early Withdrawal
401(k) plans were created to help people save for retirement in a tax-advantaged way. To encourage savings, the IRS placed an age requirement on 401(k) withdrawals. Any funds that are withdrawn before 59½ — the minimum age set by the IRS — will be subject to a hefty 10% penalty.
For example, if you take an early 401(k) withdrawal of $50,000, your penalty alone will eat up $5,000 of your distribution.
“In addition, the funds withdrawn will be added to your taxable income and reported on your tax returns,” said Shelli Woodward, a tax analyst with Merchant Maverick.
The amount you’ll pay in taxes on your 401(k) withdrawal depends on your tax bracket. Tax rates in the U.S. range from 10% to 37%. As a result, that same $50,000 distribution could result in an income tax burden of anywhere between $5,000 and $18,500. For folks in the highest tax bracket, nearly half of the $50,000 distribution would be eaten up by taxes and penalties.
Of course, it’s also important to consider the long-term financial penalties of an early 401(k) withdrawal. While these aren’t penalties imposed by the IRS, they are natural consequences of taking funds from your retirement savings.
“Besides the tax implications, you are also eating into your retirement savings,” Woodward said. “This account is intended to help you save for the future and cover expenses when you are no longer working. If you take that out now (or before you retire), you will not have this safety net when you planned on needing it.”
Before considering taking an early withdrawal from your 401(k), look at what other alternatives are available to you. Depending on the interest rates available and your current income tax rate, the cost of borrowing money elsewhere may outweigh the short-term and long-term financial consequences of taking money from your 401(k).
How to Avoid the Early Withdrawal Penalty
Ideally, you would be able to find another way to cover your financial emergency besides taking money from your 401(k). But in case that isn’t possible, you may be able to avoid the early withdrawal penalty — though often not the income taxes — on an early 401(k) distribution.
“The IRS will waive the 401(k) early withdrawal penalty under a number of specific circumstances, most of which relate to financial hardship,” said Daniel Anderson, an investment banking analyst and the founder of TheMoneyManiac.com.
The IRS allows you to take hardship withdrawals from your 401(k) without the 10% penalty. To meet the requirements of a hardship withdrawal, it must be because of “an immediate and heavy financial need,” according to the IRS.
Examples of situations eligible for hardship withdrawals include:
- Medical expenses for you, your spouse, or your dependents
- Costs related to the purchase of your primary residence
- Tuition and fees related to higher education for you, your spouse, or your children or dependents
- Payments required to prevent an eviction or foreclosure from your primary residence
- Funeral expenses
- Costs related to the repair of damage to your primary residence
In addition to hardship withdrawals, there are several other situations where the IRS allows you to make a penalty-free withdrawal from your 401(k). First, a distribution can be made from a 401(k) to a beneficiary if the participant has passed away. Other situations where the IRS allows early withdrawals include:
- A qualifying disability
- A series of substantially equal periodic payments
- Separation from service during or after the year you turn 55
- A payment made to someone else under a qualified domestic relations order (QDRO), usually after a divorce
- Medical expenses up to the amount allowable as a medical expenses deduction
Remember that any of the situations above, while they don’t require the 10% penalty, will still require that you pay income taxes on the amount you withdraw.
If you’d rather avoid income taxes or don’t want to permanently take money from your 401(k), you could also consider a 401(k) loan. Depending on your employer’s plan rules, you may be able to borrow up to 50% of your vested 401(k) balance, for a maximum of $50,000. Keep in mind that you’ll have to repay the loan within five years, and if you leave your job before then, you may be on the hook for the full balance right away.
Alternatives to a 401(k) Early Withdrawal
As we mentioned, a 401(k) early withdrawal can be used in a financial emergency, but it shouldn’t be your first choice. The good news is there are plenty of other options available to you.
“There are several alternatives to an early withdrawal from retirement, however, most of them mean going into debt,” Woodward said. “The only difference is your credit will not be used in determining your eligibility for a 401(k) loan. Your credit will be used for credit cards (including zero-interest ones), HELOCs, personal loans, and any other type of loan.”
Your creditworthiness is a major factor when you’re borrowing money. Some of the options below may only be available if you have good credit. In other cases, a poor credit score could make the loan cost-prohibitive.
A personal loan is a type of unsecured debt, meaning it doesn’t require any sort of collateral. The good news about personal loans is they can be used for any purpose, and you often don’t have to disclose that purpose to the lender.
Personal loan terms most often range from one to five years. During that time, you’ll make fixed monthly payments until you repay the loan. Your interest rate for a personal loan depends on your creditworthiness. While borrowers with excellent credit may have access to low interest rates on personal loans, many borrowers will be stuck with rates of 10% or higher.
Home Equity Loan or HELOC
If you own a home with equity built up, a home equity loan or home equity line of credit (HELOC) can be a low-interest alternative to a personal loan. This type of loan is often referred to as a second mortgage because the loan is secured by your home. In other words, if you default on the loan, your lender may have a right to foreclose on your home.
One of the major benefits of a home equity loan or HELOC over a personal loan is the interest rate. Loans that are secured by homes — including mortgages, home equity loans, and HELOCs — often have some of the lowest interest rates on the market. As a result, the loan will cost you less money over the long term.
It’s important to proceed with caution if you’re considering a home equity loan or HELOC. As we mentioned, these loans are secured by your home. If you can’t make your monthly payments, you risk having the lender take your home. As a result, you should avoid this option if you think for any reason you may not be able to repay the loan on time.
Credit cards are often the worst tool in a financial emergency because of their notoriously-high interest rates. However, there are ways around this. Many credit cards offer an introductory APR period during which you’ll pay 0% interest on all purchases for a certain amount of time, often ranging from 6-18 months.
If you can pay off the credit card during the introductory period, you essentially just got a 0% loan, making it one of the best options available to you. However, if you don’t pay off the loan during that period or soon after, your interest expenses can add up quickly.
“If your financial situation does not improve, credit cards can become extremely expensive once their high interest rates kick in,” Anderson said.
Pause 401(k) Contributions
Depending on how immediate and how large your financial emergency is, you may be able to get by simply by pausing your 401(k) contributions and rerouting those funds toward your biggest financial need.
“Pausing contributions to your 401(k) plan can free up cash in the short term,” Anderson said. “However, if your employer offers a match, missing out on those free contributions can become very costly.”
Another downside to pausing your 401(k) contributions is you’re likely to see your tax liability increase. 401(k) contributions are made pre-tax, meaning they help to reduce your taxable income. If you pause those contributions and receive that money on your paycheck instead, it will be subject to taxes.
Admittedly, this advice won’t help you if you’re already in the midst of a financial emergency. However, one of the best ways to avoid an early withdrawal from your 401(k) in the future is by having an emergency fund.
Financial experts generally recommend saving between three and six months of your monthly expenses in an emergency fund. This money can help you in the case of a job loss or another financial emergency.