Before you go putting too much money into your employers retirement plan to try to hide it from Uncle Sam, it may help you to understand the 401k withdrawal rules and what is involved with getting your money back. For example:
- What if you have an emergency and you need the money right now?
- What if you are planning on buying a house?
- What if you are plan to retire early (before age 59-1/2)?
It’s Always Your Money:
The first thing you should know is that when it comes to putting your money into your employer’s 401k retirement plan is that the money is always yours (not your employers)!
This is a very common misconception for people are unfamiliar with how a 401k works. They sometimes mistakenly think that if they put their money into this plan and then lose their job or get fired, then they lose it. This is just not true.
Your money is always your money; by law. Whatever you invest into your account is yours to keep.
Now keep in perspective that this IS an investment account. And just like any investment account, the assets can either go up or they can go down (depending on the market conditions and which investments you picked). So it is entirely possible that you could end up with less or more money than you started.
The one thing you may surrender if you lose your job are the contributions that your employer put in for you (called employer contributions). Usually your employer contributions are subject to special waiting periods called “vesting” where you have to wait a short amount of time before the money is truly considered yours.
The Basic 401k Withdrawal Rules:
Because of the special tax treatment you’re going to receive for your money, the primary rule for 401k withdrawals is that:
• You can’t take out your money until age 59-1/2
This is the price you pay for being able to grow your money tax free until you are financially or legally ready to take it out. That’s not a bad trade off when you consider how much extra money that could result in for you over the long run!
Once that day finally comes when you do retire and start taking the money out, you owe taxes on it just like you would with any of your other income.
In fact, because the IRS does not want to wait for forever to collect their taxes, one of the lesser known rules to 401k withdrawals is something called “required minimum distributions” or RMD. This rule basically states that you are required to start taking out your money by April 1 of the calendar year that you turn age 70½ (or April 1 of the calendar year after retiring, whichever is later). Sarcastically, some people have also dubbed this a “reverse hold-up” (instead of someone forcing you to give them their money, they force you to give it to yourself).
Avoiding the 10% Penalty:
If for any reason you need to take money out of your 401k sooner than age 59-1/2, there is generally a 10% penalty to be paid on it (on top of the taxes you are already required to pay).
However, as with most of the laws on the books, there are exceptions to these rules. A few of them include:
• The employee’s death
• Complete disability for the employee
• Separation from service in or after the year the employee reached age 55
• Substantially equal periodic payments under section 72(t)
• A qualified domestic relations order
• Certain deductible medical expenses
• A loan (subject to your employer’s restrictions)
Each one of these exceptions carries their own set of rules and obligations that you must comply with (posted at length on the IRS 401k resource guide). It is highly advised that you speak to a legal or financial representative before using any of them.
In addition, since the 401k vs IRA effort is intended to help you create a secure retirement, it is not recommended that you take money out of your 401k (or any retirement plan) early unless it is truly your last resort. The reason for this is because when you do, that money is no longer in your account generating returns. This disrupts the effects of compound interest which can alter the potential overall balance of your account greatly. Tread with caution if you must exercise this option!
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