Withdrawing from Your 401(k)
The underlying premise for building equity in a 401(k) plan is to have resources for you to use when you stop working. Because it is structured using the benefit of tax-deferred dollars, at some point Uncle Sam is going to want to see some tax revenue from those tax-deferred contributions and the earnings that will have amassed over the years. The rules for beginning to withdraw from the account — not to be confused with rolling it over, which is discussed separately — vary a bit from IRA rules. Here are some of the benchmarks for withdrawing:
At age 55, if you leave your company, not necessarily retired, you can begin withdrawing funds from your 401(k) without a 10 percent tax penalty.
At 59½, you automatically avoid any exposure to the ugly 10 percent penalty for early withdrawal.
At 70½, you must begin taking minimum distributions if you are no longer working at the company where you have a 401(k).
The Internal Revenue Code calls for “minimum required distributions” (MRDs) from your tax-deferred account to make sure you eventually take money out of your contributory retirement plan and begin paying taxes on it. If you do not take the MRD required, you face the highest penalty in the IRS tax code, a penalty tax of 50 percent of the amount that that should have been distributed. On top of that, you still must take your normal required distribution and pay the tax on that amount also. Usually this requirement kicks in once you reach the age of 70½. According to Fidelity Investments, your MRD will be calculated by dividing the market value of your tax-deferred retirement account(s) as of the prior year end by an applicable life expectancy factor taken from the Uniform Lifetime Table. If your spouse is quite a bit younger, and he will be the sole primary beneficiary, you can use the Joint Life Expectancy Table to calculate your MRD. This will result in a lower required distribution, as you will need to stretch your account over more years. MRD proceeds are ineligible to be reinvested into an IRA or another employer-sponsored retirement plan.
A unique feature of age rules for a 401(k) is that you do not need to begin minimum withdrawals at age 70½ if you are still employed by the same company. Taxes will be collected eventually, however. This retirement vehicle cannot double as an estate-planning tool.
Companies have different ways of treating accounts for people who leave their employ before retirement. Some may allow you to leave your account there to grow until you reach age 59½. Others will want you to move it to your new employer if possible, or to take it out. Knowledge is power. Make sure you understand the rules both going in and leaving a company's retirement plan.
One factor for deciding how much to store away in a defined contribution plan is the nagging worry that you may need to get your hands on that money for an unforeseen crisis. The rules governing these plans are designed to make touching the monies in a retirement account unattractive. But sometimes things happen in life and you have to use your own resources to bail yourself out. The IRS is rather firm in requiring you to define your need as a hardship. To make a “hardship withdrawal,” you will have to demonstrate that you are facing an immediate, heavy financial need and basically you have no other options. Individual company plan rules vary, but you can be permitted to withdraw hardship money before retirement for:
Certain medical expenses
Buying your primary home
Education expenses for the coming year for you, your spouse, or your child
Preventing eviction or foreclosure on your home
Be prepared to document your need to your employer, who will release the funds to you. They will want to be sure you are not withdrawing more than you actually need for the hardship. The funds will be subject to taxes, and perhaps other penalties depending on your age.
It may be possible to take a loan from your defined contribution plan. You want to be careful with this strategy, however. On the plus side, you are borrowing from yourself and not a bank. On the minus side, the funds you use are taken from your account and therefore are not able to generate any earnings while they are out. You are required to repay the loan with regular payments and interest. You will need to get all the particular rules for your company. One very important question to get answered is whether you might be required to repay the loan in full should you leave their employ.
You will pay taxes twice with a loan from your retirement account. First, when you repay the loan it will be from your paycheck, after taxes. Once the funds are repaid they will be characterized as pre-tax dollars, which is the nature of the account. This means that later, when you begin to withdraw funds, they will be subject to income tax — again.
If your plan allows loans, there are caps on how much can be borrowed. It will be the lesser of 50 percent of your vested balance (remember that vesting takes time, so you may have more total dollars in your account than are fully vested) or $50,000. These limits may be cumulative. If you have already borrowed, you may not be able to get your hands on all you need now. Rules vary by plan, so be sure you find out what you can do with yours before you find yourself up against a wall desperate for cash.
Tax Consequences for Loans
There are no initial tax consequences when you take a loan from your retirement account. They could be triggered if you fail to repay the loan, or if you do not meet the terms of the loan for repaying it. If you are under age 59½ and don't repay the loan, it can be considered a distribution with the 10 percent penalty and the imposition of income taxes. It may be possible to duck these financial hits if you are able to roll over the balance to an IRA or another employer-sponsored plan. Be warned, there is a sixty-day window to do this, however. And keep in mind that the interest you will be paying for the loan is not tax deductible.