A 401(k) is designed for retirement savings. If you choose to use the money for any other purpose, you might owe penalty taxes. In some cases, you might not even be allowed to take the distribution. Regardless of when you make a 401(k) withdrawal, you'll owe taxes on the distribution. If you need the money from your 401(k) only for a short time, a loan might satisfy your needs without subjecting you to taxes or penalties.
Some retirement accounts, such as an individual retirement account, allow you to take distributions whenever you like, although you may still face taxes and penalties. A 401(k) plan does not allow you access to your money until you either turn age 59 1/2 or separate from service with your current employer. Generally, however, most employers permit 401(k) participants to take premature in-service withdrawals with proof of a financial hardship. Events that qualify as a financial hardship include disability, the first-time purchase of a home and educational, medical or funeral expenses. The amount of the hardship withdrawal cannot exceed the amount of the immediate financial need, and it can come only from an employee's elective deferrals, not from any earnings.
To take a 401(k) withdrawal, you must contact your 401(k) plan administrator. Some firms may allow you to complete the transaction online or over the phone, but others may require written authorization. This is particularly true in the case of a premature withdrawal, which may require documentation of the financial need.
Pay Applicable Taxes
Money you take out of your 401(k) is taxable income, just like your salary and wages. You can avoid taxation by rolling over your distribution to another retirement plan, such as an IRA, within 60 days of your withdrawal. Otherwise, you must include the distributed amount in your taxable income when you file your taxes. Distributions before age 59 1/2 are also subject to a 10 percent early withdrawal penalty, even when used for a hardship.
Consider A Loan
The Internal Revenue Service doesn't require that 401(k) plans offer loans to participants, but most employers provide them. Where loans are offered, the IRS restricts the loan amount to 50 percent of the account balance or $50,000, whichever is lower. If you take a loan from a 401(k), you don't have to report the amount of the loan as income, nor do you have to pay any early withdrawal penalties if you are under age 59 1/2. You must repay the loan in substantially equal payments at least quarterly, over a period of five years or less, unless you use the loan to buy your primary home. If you leave your job for any reason without repaying the loan, you may owe tax on any portion of the loan you don't immediately pay back.
- Making a financial plan image by Allen Stoner from Fotolia.com