When inflation skyrocketed in 2022, more and more Americans started tapping their 401Ks to help ends meet.
Despite inflation dropping to more reasonable levels in the years since, large numbers of Americans continue to take hardship withdrawals from their 401K accounts.
While it’s easier than ever to tap into your 401K for financial assistance, it's important to fully understand all your options—and the implications of each. Let's take a look at those options, their associated rules and costs, and the short- and long-term implications.
Withdrawal and Loan Options
401K early withdrawal
An early withdrawal occurs whenever money is taken out of a 401K before the plan holder turns 59½. Generally, this move comes with a 10% penalty, as well as taxes on the entire amount withdrawn.
Here’s an example: If you’re in the 22% tax bracket and you withdraw $10,000 from your 401K, you’d pay $2,200 in taxes and a $1,000 penalty, resulting in $6,800 to take home. If you needed the full $10,000, you would have to withdraw nearly $15,000 to account for the penalty and taxes.
401K hardship withdrawal
If you have an “immediate and heavy financial need,” and your 401K administrator (typically your employer or other third party that manages the plan) decides that you qualify for a hardship withdrawal, you can dip into your 401K for an amount limited to what’s necessary to satisfy that need. The IRS will waive the 10% penalty if certain scenarios apply, including:
- You redistribute a 401K as part of a divorce.
- You become or are disabled.
- You rolled the account over to another retirement plan (within 60 days).
- You were a victim of a disaster for which the IRS granted relief.
401K loan
Depending on what your employer allows, you can take out a loan of up to 50% of your 401K savings—up to $50,000—over a 12-month period. In most cases, a 401K loan needs to be paid back, with interest, within five years. If you don’t pay it back within that time frame, the loan will be treated as a distribution. And if you’re not yet 59½, that would result in a 10% early withdrawal penalty. Unlike withdrawals, these loans (when paid back in time) don’t come with a penalty or taxes, and the interest you pay goes back into your account.
New SECURE Act 2.0 benefits
The SECURE Act 2.0, passed in December 2022 to expand coverage and increase retirement savings, added and expanded exceptions to the 10% penalty for early withdrawals. Additional exceptions include:
- Up to $22,000 for disaster relief (e.g., from hurricanes and wildfires).
- Terminal illness.
- Up to $1,000 per year for emergency expenses.
The legislation also expanded an exception for when an employee leaves their job. The 10% penalty doesn’t apply when employees leave their jobs after age 55 (or age 50 for qualified public safety employees). SECURE 2.0 extended the exception to include public safety officers with at least 25 years of service, regardless of age.
For many of these exceptions, withdrawals may be repaid within three years of the time the distribution is received. There is no obligation or penalty if you’re unable to pay it back. However, by repaying, your future earning power will grow.
Tradeoffs to consider
All of the options above can be useful—and sometimes even necessary—tools for providing short-term aid, but the tradeoff is what you’d lose over time.
Even as the market goes through its typical ebbs and flows, retirement accounts still historically grow 5% to 8% annually. By withdrawing funds early or taking out a loan, that growth can be substantially stunted. Say you have a 7% return on your 401K— over 10 years the $10,000 you took out would have been worth nearly $20,000. After 20 years at the same rate, you’d miss out on nearly $40,000. Check out this calculator to get a better understanding of how your 401K grows over time.
Many financial decisions come with tradeoffs, and making the decision to dip into your 401K is no different. If you have questions, contact your financial institution or a financial advisor for assistance.
