You may be familiar with the rules for putting money into a 401(k) plan, but do you know the rules for taking money out? Federal law sets some limitations for 401(k) borrowing, but there are often more restrictions specific to individual plans. And with thousands of variations out there, 401(k) plans vary from fairly flexible to much more complicated. Some may even prevent you from taking money out completely until you leave employment! So when financial plans go awry and it seems a 401(k) withdrawal is the only option… What do you do?
To answer this question, we reached out to Jason Sgrignoli, CFP®, MBA, and Branch Manager at Raymond James in Upland, CA. With his extensive experience as a CERTIFIED FINANCIAL PLANNER™, Jason was able to break down this complex issue and talk to us about in-service withdrawals from 401(k) plans.
Loans vs. Withdrawals
Though generally not advised except as a last resort, you may one day find yourself in a situation where you desperately need financial assistance and your 401(k) is the only option. Nowadays, many 401(k) plans allow you to borrow from your account instead of making actual withdrawals. Loans are attractive if you want to avoid taxes and penalties or are concerned about permanently depleting your retirement assets. And, especially after the liberalization of loan repayment rules at the end of 2017, loans are almost always the better choice.
Not only that, but if you’re considering making a 401(k) withdrawal, then taking out all available loans first is actually mandatory. As of 2018, employees must have taken all other available distributions (e.g., loans!) before even being eligible to make a 401(k) withdrawal.
These loans generally allow you to borrow up to half of your vested account balance not exceeding $50,000 for up to five years. For some flexibility, if the loan is to purchase your principal residence, you can actually increase the payback period from five to fifteen years. In most cases, employees repay these loans with interest through a payroll deduction. Just keep in mind that when you borrow, this money is no longer in your 401(k) working for you.
Withdrawing Your Own Contributions
Eligibility Requirements
If you’ve made after-tax (non-Roth) contributions, you can withdraw these funds and their investment earnings at any time. You can also withdraw your pre-tax and Roth contributions (“elective deferrals”). However, these withdrawals can only be for one of the following reasons and only if your plan allows:
- You attain age 59 ½
- You become disabled
- The distribution is a qualified reservist distribution
- You incur a hardship (i.e., a “hardship withdrawal”)
Per federal law, you can only make a hardship withdrawal if you require immediate and heavy financial assistance. Further, you can only withdraw up to the amount necessary to meet that need. In most plans, you must require the money to:
- Purchase your principal residence, or repair it if damaged by an unexpected event (e.g., a hurricane)
- Prevent eviction or foreclosure
- Pay medical bills or certain funeral expenses for yourself, your spouse, children, dependents, or plan beneficiary
- Finance certain education expenses for yourself, your spouse, children, dependents, or plan beneficiary
- Make income tax and/or penalty payments on the hardship withdrawal itself
Risks & Consequences
With hardship withdrawals, taking a tax hit is unavoidable. Unfortunately, there are other lesser-known disadvantages as well. For example, in 2018, you can’t take a hardship withdrawal until after first withdrawing all other funds and taking all nontaxable plan loans available to you. This includes loans under all retirement plans maintained by your employer. Moreover, employees are barred from making any new 401(k) contributions for six months after the withdrawal. Lastly, keep in mind that hardship withdrawals can’t be rolled over–so think carefully before committing!
Withdrawing Employer Contributions
Okay, so we understand some of the requirements and risks of withdrawing your contributions. But what about the money your employer has put in? Some plans may allow you to withdraw (at least some) vested employer contributions before you terminate employment. “Vested” means you own the contributions and they can’t be forfeited for any reason. Just like before, you can typically only withdraw vested company matching and profit-sharing contributions if you:
- Become disabled
- Incur a hardship (your employer has some discretion in how hardship is defined for this purpose)
- Attain a specified age (for example, 59 ½)
- Participate in the plan for at least five years, or
- Have had the employer contribution in your account for a specified period of time
Note: Special rules apply to the withdrawal of qualified matching contributions (QMACs) and qualified nonelective contributions (QNECs). These are special employer contributions made to help meet 401(k) plan nondiscrimination requirements. They are generally subject to the same withdrawal restrictions that apply to your own elective deferrals, but are not available for hardship withdrawal in 2018.
Taxation
So if you do decide to take money out of your 401(k), what’s next? Your own pre-tax contributions, company contributions, and investment earnings are all subject to income tax once withdrawn from your plan. If you’ve made any after-tax contributions, they’ll be non-taxable when you withdraw them, and each withdrawal will include a pro-rata portion of taxable and nontaxable dollars (if any).
The IRS taxes Roth contributions and investment earnings on them separately. Withdrawals of “qualified” distributions will be entirely free from federal income taxes. On the other hand, “nonqualified” withdrawals are each deemed to carry out a pro-rata amount of nontaxable Roth contributions and taxable investment earnings. A distribution is “qualified” if you satisfy a five-year holding period and either reach age 59 ½ or become disabled. The five-year period begins on the first day of the first calendar year you make your first Roth 401(k) contribution to the plan.
The taxable portion of your distribution is typically subject to a 10% premature distribution tax plus any income tax due. Exceptions to the penalty include distributions after age 59 ½, distributions on account of disability, qualified reservist distributions, and distributions to pay medical expenses.
Rollovers and Conversions
Rollover of Non-Roth Funds
If your 401(k) withdrawal qualifies as an “eligible rollover distribution” (and most, except hardship withdrawals and required minimum distributions after age 70 ½, do!), you can roll over all or part of the withdrawal tax free to a traditional IRA or to another employer’s plan that accepts rollovers. In this case, your plan administrator will give you a 402(f) notice. This notice will explain the rollover rules, withholding rules, and other related tax issues. (Your plan administrator will withhold 20% of the taxable portion of your eligible rollover distribution for federal income tax purposes if you don’t directly roll the funds over to another plan or IRA.)
You can also roll over (“convert”) an eligible rollover distribution of non-Roth funds to a Roth IRA. Some 401(k) plans even allow you to make an in-plan conversion. These allow you to request an in-service withdrawal of non-Roth funds and transfer those dollars to a Roth account within the same 401(k) plan. In either case, you’ll pay income tax on the amount you convert less any nontaxable after-tax contributions you’ve made.
Rollover of Roth Funds
If you withdraw funds from your Roth 401(k) account, there are restrictions on how you can roll over those funds. Roth 401(k) withdrawals can only be rolled over to a Roth IRA or other Roth 401(k)/403(b)/457(b) plan that accepts rollovers. However, it’s important to understand how a rollover will affect the taxation of future distributions from the IRA or plan. For example, if you roll over a non-qualified distribution from a Roth 401(k) account to a Roth IRA, the Roth IRA five-year holding period will apply when determining if future distributions from the IRA are tax-free qualified distributions. Basically, this means you won’t get credit for the time those dollars were in your 401(k) plan.
Action Items
- If you haven’t already, be sure to familiarize yourself with the terms of your employer’s 401(k) plan to understand your particular withdrawal rights. A good place to start is the plan’s summary plan description (SPD). Your employer will give you a copy of the SPD within 90 days after you join the plan.
- If you have never met with a financial planner, we cannot recommend this enough as a way to assess your financial health and gain valuable insights and advice from an expert. Not sure where to start? Give us a call and we’d be happy to get you in touch with one of our valued partners. (Especially if you are considering taking a 401(k) withdrawal or loan!)
What do you think?
Have you ever withdrawn funds from your 401(k) plan? What recommendations would you give a friend or colleague in this situation? And if you’re an employer, when was the last time you revisited your plan? Contact us today to learn about our customized, qualified Retirement Plans and Financial Wellness services. We’ll work with you to maximize your employees’ investments, bring you the greatest tax benefit, and save you time and money. Additionally, we offer FinFit and ZayZoon services at no cost to you to provide financial education and assistance to your employees!
And as always, make sure you’re following us on Facebook, Twitter, and LinkedIn to make sure you never miss a beat! All month, we’re focusing on Financial Wellness, so stay tuned for even more tips and tricks to be financially well!
Disclaimer: Southland Data Processing, Inc. (“SDP”) is not a financial advisor. This information, developed by an independent third party, has been obtained from sources considered to be reliable, but SDP does not guarantee that the foregoing material is accurate or complete. This information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. This material is general in nature, and applicability of the principles discussed above may differ substantially in individual situations. Please consult with the appropriate professional prior to making major financial decisions. SDP is not responsible for any inadvertent losses that may occur due to application of the above information.
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