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401(k) Loan vs. IRA Withdrawal: An Overview

Dipping into a retirement account early is rarely an investor’s Plan A, but there could come a time when an individual sorely needs cash and has no other options. Under certain circumstances, drawing on a 401(k) or individual retirement account (IRA) might be your only real choice.

Unfortunately, the IRS doesn’t make it easy to tap these tax-advantaged accounts. Typically, you’ll be assessed a 10% penalty on any funds withdrawn out of a traditional 401(k) or IRA account before the age of 59½. The penalty is on top of the ordinary income tax rate you normally pay on distributions.

However, the IRS and many retirement plans allow for hardship withdrawals, which are distributions from an IRA or 401(k) that avoid the 10% penalty. These exceptions to premature withdrawals before the age of 59½ include funds for medical expenses and if the IRA owner suffers total and permanent disability.

Granted, the decision to use this money for something other than your retirement shouldn’t be taken lightly. But if you can get around the IRS penalty, the idea starts to make a little more sense.

Key Takeaways

  • Withdrawing money early from a 401(k) or IRA will result in an additional 10% penalty. There are a few exceptions to this rule.
  • You can borrow from your 401(k) account and pay back the money over five years.
  • You can withdraw money early from an IRA without penalty for a few specific reasons.
  • Such as placing a down payment on a first home or paying for college tuition.
  • Borrowing from your retirement accounts is essentially taking a loan out from oneself.

Sometimes It Pays to Borrow From Your 401(k)

401(k) Loan

This is probably the easiest way to access retirement money early for many workers. Some plans allow you to borrow from your 401(k) for various reasons.

With a 401(k) loan, you can withdraw the lesser of $50,000 or half the vested balance in your account. You then repay your account over a period of up to five years.

Some employers allow a longer period if you borrow to buy a home. Some plans allow the borrower to reimburse the account early with no pre-payment penalty. It’s worth noting that you typically pay back a little more than you took out of the account. This “interest” actually works to the borrower’s advantage. Because the funds go into your account, you’re essentially making up for some of the interest or capital gains the money would have accrued had you not withdrawn it from the fund. These loans are quick and easy to access, don’t hurt your credit rating (assuming you pay the loan back), have repayment flexibility, and are affordable with no to low origination fees.

Some downsides? Most 401(k) plan providers and platforms will charge fees to process and service a loan, which adds to the cost of borrowing and repayment. Also, not all employers offer these loans. Your odds of getting one are better if you work for a large company.

You may also withdraw up to $5,000 without penalty to deal with a birth or adoption under the terms of the SECURE Act of 2019.

IRA Withdrawal

Traditional IRA accounts don’t allow loans, but they do come with certain perks 401(k)s don’t offer. The government offers penalty-free IRA distributions, for example, for those who want to further their education or buy their first home.

The tuition exemption applies to individuals who use retirement money to pay tuition at an IRS-approved college and for books and supplies. If you take enough credits, you also can use the funds for room and board without penalty. You even can use the distribution to pay education expenses for your spouse, child, or grandchild without worrying about the extra 10% hit.

The tax code allows you to use $10,000 of IRA funds to pay for a first home. If your spouse also has an individual retirement account, you can access up to $20,000 for a down payment and closing costs.

One of the lesser-known ways to access a traditional IRA is by setting up substantially equal periodic payments (SEPPs), allowing you to make one or more withdrawals a year for either a five-year period or until you reach age 59½ whichever is longer. While SEPPs allow you to avoid the 10% early withdrawal penalty, you’re still responsible for paying your ordinary income tax rate on the distributions.

Special Considerations

When you withdraw money from your retirement account, you may face tax-related consequences, such as paying a 10% penalty tax, plus state and federal taxes on the amount you withdraw early. Paying these taxes may add up to a considerable amount of money, eating into the cash you withdraw.

There are instances where you can withdraw money from a 401(k) or IRA without paying the penalty. However, just because you don’t have to pay the penalty doesn’t mean you won’t owe taxes on the cash you withdraw, which the IRS will consider income. Withdrawals from traditional IRA and 401(k) plans are taxed at your normal income level because these accounts are funded with pre-tax dollars.

If you contribute to a Roth IRA, you can withdraw your contributions because Roth IRAs are funded with after-tax income. When you turn age 59 and a half, you can withdraw your earnings without being hit with taxes or penalties, as long as you follow the five-year rule.

If you borrow money from your retirement accounts, you do not have to pay penalties or taxes on the funds, as long as you pay yourself back. Early withdrawals from your retirement account are not often worth the amount of taxes you will be required to pay. If you have an emergency, it may be prudent to investigate a loan from your account. Another type of retirement loan is called a bridge loan. You can use the cash you need when you take out a bridge loan, but you have a 60-day window to deposit the amount you withdrew into a new IRA. If you wait too long, you will be hit with taxes and penalties by the IRS.

What Are the Early Withdrawal Penalties on a 401(K) And an IRA?

The early withdrawal penalty is a 10% tax on the amount withdrawn, plus you will be required to pay additional state and federal taxes on the withdrawn funds.

How Do You Determine the Minimum Withdrawal Amount on a 401(K) And IRA?

Your required minimum withdrawals (RMD) are calculated by dividing the previous Dec. 31 retirement plan balance by a life expectancy factor dictated by the IRS, which publishes tables in Publication 590-B. You select the life expectancy table based on your particular situation. Of course, the IRS can’t see into the future, so there is always the chance you will need fewer (or more) funds than expected.

Which Retirement Account Should I Withdraw From First?

If you are lucky and financially secure enough to have multiple retirement accounts, most experts recommend you first spend down taxable assets, like bank accounts or stock accounts, then pre-taxed retirement accounts, and finally after-tax accounts, like a Roth IRA.

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