Taking Money Out of Your 401(k): What to Expect

by | Nov 1, 2021 | Blog

Saving money into a 401(k ) plan is a great way to help your future self. But you should not plan on touching this money until later in life. Exactly when that will be depends on the individual.

The rules state that you cannot withdraw money from your 401(k) until you are at least age 59 ½. And if you do so, you will incur a 10% penalty, no good.

But what if you really need it? Are there ways to access these funds without incurring the penalty?

In this blog post we’ll cover what to expect when taking a 401(k) loan, potential early withdrawals and the recommended option of waiting until age 59 1/2.

Please consult with a financial professional before making any decisions on whether or not to access your 401(k) funds.

Taking Money Out of Your 401(k): What to Expect

Should You Take a Loan?

We hate to answer a question with another question but we often do in this case. When someone asks whether or not they should take a loan from their 401(k) account we usually respond with, well do you really NEED the money? What’s it going to be used for?

Our general answer to this question is not unless it is COMPLETELY NECESSARY.

The reason this is our go to answer is because you will 1.) be interrupting the compounding of your investments and 2.) most 401(k) loans are paid back PLUS interest. Depending on the plan, you’re likely to see a prime interest rate, plus one percent. So you will be paying back more than you took out, while losing potential growth in the investment value.

Loan repayments usually involve a deduction from your paycheck over a 5 year time horizon. You can of course pay back more, and finish sooner. But this will usually be the default.

There are usually hardship withdrawal provisions in most 401(k) plans. Meaning if you meet certain criteria, you will be allowed to access the money. But again, please consult with your plan administrator before withdrawing any money.

Rule 72(t)

If you are still working and pull money out of your 401(k) before age 59½, you will almost certainly pay a 10 percent early withdrawal penalty plus income taxes on the money you take out. But you might be able to make early withdrawals with the help of IRS Rule 72(t).

Rule 72(t), based on life expectancy, lets you schedule fixed income withdrawals for five years or until you reach 59-1/2, whichever is longer. It lets you receive fixed, equal payments according to IRS calculations.

First things first: make sure you can do this. Talk with your employee benefits officer at work, and see that the Summary Plan Description (SPD) permits non-hardship withdrawals. Talk with your financial or tax advisor to make sure it is an appropriate move for you given your overall financial strategy.

Age 59 ½

This is the age when funds in your 401(k) are meant to be taken out. It’s why financial planning is so focused in your late 50s and early 60s. Along with taking Social Security it is a financially complex time.

But it can also be the most rewarding time. These are usually your highest earning years. And the future seems to come into focus for a lot of folks.

It’s a big change to now be taking money out, instead of putting money in, to the 401(k). There needs to be a lot of thought put into this process. How much are you going to need each month to live on? Should the investment allocation change? If so, what is best? Should we set aside cash to make sure the withdrawals can happen? If so, how much? If there are other streams of income, how does that affect things? How do we take money out in a tax prudent way?

We start our financial planning process with cash flow projections. We figure out how much is coming in and how much is going out. It may sound basic. But all of those questions above revolve around this simple equation.

We’ve seen folks max out their 401(k)s but have nothing to live on in the day-to-day. We’ve seen folks spend frivolously in the their day-to-day while not saving money for the future. The point of the cash flow planning is not to judge, or fit folks into a one-size fits all approach.

It’s to help identify what is important for them. And what will be important for them in the future.

How Are 401(k) Withdrawals Taxed?

When you eventually start drawing down your 401(k), hopefully after age 59 1/2, the withdrawals will be taxed as ordinary income. That’s because you haven’t paid tax on this money yet, so technically this is the first time you are recognizing it as income.

There are a host of strategies for how to take 401(k) distributions in a tax-prudent manner. But that is for another blog post.

If you are saving money into a 401(k) it’s important to understand the plan documents as best you can. While they can be complicated, taking the time to understand the rules surrounding your money will certainly be a useful exercise. At least then, you’ll know what your options are.

There are no one-size fits all approaches to personal finance and investing. So if you have questions about saving in your workplace retirement plan, don’t hesitate to reach out. That way we’ll be able to understand your situation and give you the best advice FOR YOU.

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