What’s the 401(k) Early Withdrawal Penalty?

A 401(k) is a tax-advantaged retirement account that many employers offer. In fact, data from the Bureau of Labor Statistics shows that about 64% of workers have access to a 401(k) plan or another defined contribution plan.[1] Because of how popular they are, 401(k)s also happen to be many workers’ first investment accounts.

401(k) plans were designed with a very specific purpose in mind: saving for retirement. Because of that, you generally have to be at least 59½ to start withdrawing funds.[2] If you withdraw money earlier than that, you’re likely to be on the hook for early withdrawal penalties.

The good news is there may be ways to avoid the financial hit of taking an early 401(k) withdrawal. Keep reading to learn the penalties and taxes that apply to early 401(k) withdrawals and how you might be able to sidestep them if you need to get cash out of your account.

The IRS imposes an early distribution penalty of 10% on withdrawals from a 401(k) plan that occur either before you reach age 59½ or that don’t meet one of the exceptions (which we’ll cover in more depth below).[2]

“The early withdrawal penalty is 10%,” says Ryan McCarty, a Certified Financial Planner and owner of McCarty Money Matters. “That doesn’t sound like a lot, but when you tack on the already needed taxes, it ends up being quite a stack.”

The 10% penalty applies to the entire amount you withdraw from your 401(k). For example, if you withdraw $100,000 from your account before you reach age 59½, you’ll pay an early distribution penalty of $10,000.

The early distribution penalty isn’t the only cost you’ll have to worry about when you withdraw funds early from your 401(k). You’ll also pay income taxes on your withdrawals. In fact, taxes apply when you take money from your 401(k), regardless of whether it’s an early withdrawal.

The amount of taxes you’ll pay on your 401(k) distributions depends on your income tax rate, since these distributions are taxed as income. Here are the income tax brackets for the 2022 tax year.[3]

So if you took a $100,000 early withdrawal from your 401(k) with a 10% penalty and you are in the 22% tax bracket, your total tax would come to 32%. On a withdrawal of $100,000, that 32% adds up to $32,000, leaving you with just $68,000.

The 10% penalty on early withdrawals can be a major financial burden, especially on top of the income taxes you have to pay. But there are a few ways to take money from your 401(k) before age 59½ and still avoid the 10% penalty. They are:

Hardship withdrawals

The federal government allows you to withdraw money from your 401(k) plan early if you can demonstrate an immediate and heavy need. Situations in which a hardship withdrawal may be allowed include:

• Expenses for medical care for the employee, their spouse or their dependents

• The purchase of a principal residence, not including mortgage payments

• Payment of tuition and other higher education expenses

• Eviction or foreclosure from the employee’s primary residence

• Funeral expenses

• Expenses to repair damage to a principal residence if they would qualify for the casualty deduction[2]

If you can demonstrate an immediate and heavy need, you can then only withdraw enough money to fulfill that need. For example, if you need $5,000 to pay back rent, interest and fees to avoid eviction, then you can only withdraw up to $5,000.

Substantially equal periodic payments (SEPP)

The IRS allows you to withdraw funds from your 401(k) plan before age 59½ if you take a series of substantially equal periodic payments over your entire life expectancy. To use this exception, you must actually intend to keep withdrawing those equal payments. If you modify them before age 59½ (or after five years if you’ve already passed that age), then you’ll have to pay the 10% penalty on the entire amount you’ve withdrawn.[4]

Rule of 55

Under the Rule of 55, you can begin taking early 401(k) distributions without a penalty if you leave your job at age 55 or older.[2] This rule applies regardless of whether you were fired, laid off or quit your job.

Tip

The Rule of 55 only applies to your 401(k) plan with your current employer. It doesn’t apply to 401(k) plans with previous employers. If you’re going to be taking advantage of the Rule of 55, consider rolling all of your previous 401(k) accounts into your current plan so they’re also eligible.

401(k) loans

Many 401(k) plans allow you to take loans from your account, which you’ll have to pay back with interest over time. As long as you pay the loan back, you won’t pay income taxes or the 10% penalty.

There are a few requirements a 401(k) loan has to meet to help you avoid taxes and penalties:

• It can’t exceed 50% of your vested account balance

• It can’t exceed $50,000

• It must be repaid within five years unless you use it to buy your main home

• It must be repaid in substantially level payments at least quarterly[2]

There are a few more things to keep in mind before you consider taking a 401(k) loan. First, if you fail to repay the loan on time, the amount left unpaid is considered a distribution and is subject to taxes and penalties. Additionally, if you leave your job while you have an outstanding loan—whether you quit or are fired—you may have to repay the full loan amount immediately.[5]

IRA rollovers

Another way to avoid the 401(k) early distribution penalty is to roll that money over into a traditional IRA, or individual retirement account, instead of just withdrawing it from your retirement account. The money will still be tied up in a retirement account and can be subject to a 10% penalty if you withdraw it early. However, you can take advantage of additional early withdrawal exceptions. These include:

• Death or disability

• Qualified higher education expenses

• Qualified first-time home purchase

• Unreimbursed medical expenses

• Health insurance premiums while unemployed

• Distributions to military reservists[6]

If you decide to roll your 401(k) contributions over to a Roth IRA, it’s even easier to withdraw funds without a penalty. In the case of a Roth IRA, you can withdraw your contributions—though not your earnings—without penalty five years after the conversion.

It’s also important to note that 401(k) rollovers can’t be done at any time. Instead, there has to be a qualifying event. For example, “if you have the opportunity to roll money from your 401(k) to your IRA, you have typically either quit, retired or been fired from your job,” says McCarty.

According to financial experts, the answer is usually no.

“Taking an early withdrawal from your retirement account is a last resort,” says McCarty. “Why would you want to give the government even more money while, at the same time, robbing yourself of future growth on those dollars?”

The money that you withdraw no longer has the opportunity to grow and compound. Imagine that you withdraw $25,000 from your 401(k). After taxes, the portion you get to keep will be considerably lower, especially if you have to pay the 10% penalty.

But what if you left that $25,000 in your account for another 25 years? If you have an annual return of 10%, then that $25,000 would grow to more than $270,000 during retirement.

If you do have to withdraw funds from a retirement account, McCarty recommends opting to first withdraw from your Roth IRA if you have one. Since you’ve already paid income taxes on the funds in the account, you won’t pay taxes or penalties on the amount you withdraw.

It may be tempting to withdraw money from your 401(k) when you leave a job. But remember: You’ll have to pay that 10% penalty. Instead, you have options for moving the money in the account without incurring any additional costs, such as:

Rolling your 401(k) over to a new 401(k)

If you start a new job where your employer offers a 401(k) plan, you can choose to roll your balance over to the new plan. You won’t pay income taxes or the 10% penalty on the funds.

Rolling your 401(k) IRA over to an IRA

Instead of rolling your money into a new 401(k) plan, you can choose to roll the money over into an IRA. The rollover happens in one of two ways: Either you have a direct rollover or you receive a check for the money in the 401(k).

In the case of a direct rollover, you won’t have to worry about anything except deciding how to invest the money once it’s in your IRA. But if you receive a check for the funds, you’ll have 60 days to deposit it into another tax-advantaged retirement account or risk being subject to income taxes and the 10% penalty.[7]