Deferring Social Security payments, rolling over old 401(k)s, setting up IRAs to avoid the mandatory 20% federal income tax, and keeping your capital gains taxes low are among the best strategies for reducing taxes on your 401(k) withdrawal.
You're age 59 ½ to age 73, or 75
If you have a 401(k) plan sitting with a former employer, you can begin accessing those funds as early as 59½. You'll pay ordinary income taxes on amounts withdrawn but no penalty tax.
The 60-Day Rule
However, you can also rollover your 401(k) account by cashing it out and then depositing that money into a new account (an “indirect rollover”).
But, no, you don't pay income tax twice on 401(k) withdrawals. With the 20% withholding on your distribution, you're essentially paying part of your taxes upfront. Depending on your tax situation, the amount withheld might not be enough to cover your full tax liability.
The short answer is that yes, you can withdraw money from your 401(k) before age 59 ½. However, early withdrawals often come with hefty penalties and tax consequences.
Key Takeaways
Taking an early 401(k) withdrawal is extremely costly, so it should only be used as a last resort. The only time you should consider cashing out a 401(k) is to avoid bankruptcy or foreclosure.
401(k) Tax Basics
There's no way to take a distribution from a 401(k) without owing income taxes at the rate you're paying the year you take the distribution. Except in special cases, you can't take a distribution from your 401(k) at all until you've reached age 59.5.
The short answer: It depends. If debt causes daily stress, you may consider drastic debt payoff plans. Knowing that early withdrawal from your 401(k) could cost you in extra taxes and fees, it's important to assess your financial situation and run some calculations first.
You can do a 401(k) withdrawal while you're still employed at the company that sponsors your 401(k), but you can only cash out your 401(k) from previous employers. Learn what do with your 401(k) after changing jobs.
Roll over your 401(k) to a Roth IRA
You can roll Roth 401(k) contributions and earnings directly into a Roth IRA tax-free. Any additional contributions and earnings can grow tax-free. You are not required to take RMDs. You may have more investment choices than what was available in your former employer's 401(k).
There isn't a separate 401(k) withdrawal tax. Any money you withdraw from your 401(k) is considered income and will be taxed as such, alongside other sources of taxable income you may receive. As with any taxable income, the rate you pay depends on the amount of total taxable income you receive that year.
The Only Way to Safely Implement the 7% Rule
A GLWB allows you to withdraw up to 7% of your annuity's value annually, ensuring you receive income for life, even if the annuity's balance is exhausted.
If you withdraw from your 401(k) before you reach age 59½, you may have to pay a 10% additional tax on the distribution. This tax applies to the amount received that you must include in income. The 10% tax will not apply to distributions before age 59½ if you qualify for an exemption.
When will the loan be due? The “termination date” will either be your last day of employment with the company or the date your employer set as the last day the plan is active. You must pay off the loan in full no later than 90 days from the termination date.
One of the easiest ways to lower the amount of taxes you have to pay on 401(k) withdrawals is to convert to a Roth IRA or Roth 401(k). Withdrawals from Roth accounts are not taxed.
By age 50, you should have six times your salary in an account. By age 60, you should have eight times your salary working for you. By age 67, your total savings total goal is 10 times the amount of your current annual salary. So, for example, if you're earning $75,000 per year, you should have $750,000 saved.
Since Jan. 1, 2024, however, a new IRS rule allows retirement plan owners to withdraw up to $1,000 for unspecified personal or family emergency expenses, penalty-free, if their plan allows.
401(k) withdrawals
Pros: You're not required to pay back withdrawals of the 401(k) assets. Cons: Hardship withdrawals from 401(k) accounts are generally taxed as ordinary income. Also, a 10% early withdrawal penalty applies on withdrawals before age 59½, unless you meet one of the IRS exceptions.
Try to avoid making 401(k) withdrawals before age 59 ½, as you will incur taxes on the withdrawal (unless you have a Roth account) in addition to a 10% penalty. If you are closer to retirement, it's smart to shift your 401(k) allocations to more conservative assets like bonds and money market funds.
Dipping into a 401(k) or 403(b) before age 59 ½ usually results in a 10% penalty. For example, taking out $20,000 will cost you $2000. Time is your money's greatest ally. But when you withdraw from your future savings, you're denying your money the chance to earn valuable interest.
In retirement, you can withdraw only as much as you need to live, and allow the rest to remain invested. You can also choose to use your 401(k) funds to purchase an annuity that will pay out guaranteed lifetime income. Internal Revenue Service. “401(k) Resource Guide - Plan Participants - General Distribution Rules.”
After other borrowing options are ruled out, a 401(k) loan might be an acceptable choice for paying off high-interest debt or covering a necessary expense. But you'll need a disciplined financial plan to repay it on time and avoid penalties.
However, if you do so before you reach the age of 59½, you'll have to pay a 10% early-withdrawal penalty and income tax on what you withdraw.