Should I take an early 401(k) withdrawal to cover expenses?

If you need funds to cover unexpected expenses, cashing out a 401(k) early can seem like a tempting option. However, it's important to know that taking early 401(k) withdrawals can negatively impact your long-term retirement savings strategy and trigger immediate taxes and penalties.

Before taking an early 401(k) withdrawal, carefully consider the potential downsides and explore other options first. Alternate sources for emergency funds—like home equity and personal loans—may allow you to cover the costs of a financial need while avoiding short- and long-term repercussions.

What are the risks of an early 401(k) withdrawal?

Taking money out of your 401(k) early can come with several potential downsides. If you withdraw funds before age 59 1/2, you'll generally face a 10% early-withdrawal penalty. If the account is a traditional 401(k), you'll also owe income taxes on the amount withdrawn.

Another drawback is that you'll have less money benefiting from compounding interest, which can leave you with less savings in retirement.

To illustrate this point, let's compare two savers: Jeff and Jason. At age 35, both have accumulated $75,000 in their 401(k) accounts. However, Jason withdraws $25,000 for a financial emergency. Even if neither person made additional contributions, after 30 years—assuming a 7% average annual investment return—Jeff would have about $570,900 in his account, while Jason would have about $380,600. That $25,000 withdrawal resulted in nearly $200,000 less in cumulative savings.

When should I consider 401(k) withdrawals?

Ideally, you'll leave your funds in your 401(k) until retirement to maximize long-term growth potential and preserve savings for future expenses. If you're facing financial challenges, it's generally best to look for alternatives before withdrawing money from your 401(k).

But if you don't have enough emergency savings or can't qualify for a loan, tapping into your 401(k) may become necessary. Depending on your employer's plan, you may be able to take a 401(k) hardship withdrawal under the following two circumstances as outlined by the IRS:

• You have an immediate and heavy financial need
• The withdrawal is limited to the amount necessary to satisfy the financial need

The need may include certain medical expenses, funeral costs, college tuition or payments needed to avoid foreclosure or eviction. Some plans may also allow hardship withdrawals for buying a home, subject to some restrictions.

To qualify for a 401(k) hardship withdrawal, you may have to provide your employer with a written statement saying you can't meet your expenses with your current income, insurance or other financial resources. Hardship withdrawals may still be subject to the 10% penalty if you're younger than 59 1/2, and withdrawals from a traditional 401(k) will also be subject to income taxes.

If you're considering using your 401(k) to pay down or consolidate high-interest debt, you may be able to negotiate new repayment terms with your lenders or access funds through a personal loan, home equity loan or line of credit. Talk to a financial professional to better understand what makes sense for your situation.

Is a 401(k) loan better than an early withdrawal?

You can avoid the 10% early-withdrawal penalty altogether if your plan allows you to take out a 401(k) loan instead of withdrawing money outright. One advantage of a 401(k) loan is that you repay yourself rather than a lender, and you won't incur the penalty as long as you repay the loan on time.

However, 401(k) loans also carry risks. If you leave your job before fully repaying the loan, the repayment timeline may shrink from 5 years to as little as 30 days—depending on your employer's plan rules. You'll also miss out on long-term growth while the borrowed funds are out of your account.

What are alternatives to early 401(k) withdrawals?

Financial stress can make it difficult to step back and evaluate your options. Before deciding to cash out or borrow from your 401(k), consider speaking with a trusted financial professional who can explain the long-term implications and help you explore other ways to access cash.

Some alternatives to consider include:

• Savings from a health savings account for qualified medical expenses
• Non-retirement savings, such as savings or brokerage accounts
• A home equity loan or line of credit
• A personal loan
• A Roth IRA withdrawal

While withdrawing money from a Roth IRA can still disrupt your retirement savings strategy, these accounts generally offer more flexibility than traditional retirement accounts. Because Roth IRA contributions are made with after-tax dollars, you can typically withdraw your original contributions at any time, for any reason, without paying taxes or early-withdrawal penalties. Just note that earnings on your investments may still be subject to taxes and penalties, depending on your age and how long the account has been open.

Additional exceptions to early-withdrawal penalties

There are two more situations in which you may be able to avoid paying a penalty for early withdrawals from retirement accounts.

• Rule of 55 withdrawals: Under the IRS rule of 55, you may be able to withdraw funds from your most recent employer's 401(k) if you leave your job during or after the calendar year you turn 55. In this case, withdrawals are generally exempt from the 10% early-withdrawal penalty. Distribution rules may vary by plan. Check with your plan administrator to confirm eligibility requirements.
• IRA early withdrawal exceptions: Like 401(k) withdrawal rules related to hardship, IRA withdrawal rules may also allow penalty-free early withdrawals in certain situations. However, the specific exceptions depend on the type of IRA and your age.

The bottom line

Because there are several short- and long-term issues to consider before using retirement funds for unexpected expenses, it's best to develop a strategy well in advance of financial emergencies. Before making a 401(k) withdrawal that may affect your retirement plans, be sure to fully understand the alternatives available to you.