6 Alternatives to Withdrawing Early From Your 401(K) & 2 Unpenalized Exceptions

By Chika

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Last Updated: February 12, 2022

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A 401(k) plan is a type of retirement savings account. Investors may prefer it over saving and investing in a brokerage account because it is not subject to federal income taxes until it is distributed.

You may be attempting to save money in your 401(k) until retirement, but life happens, and you may find yourself in a situation where you require additional funds. It's only reasonable to consider all of your options, which may involve taking money out of your 401(k) account.

Borrowing from your 401(k) or taking money out of your IRA before you retire is typically a terrible choice because it can set you back years in terms of meeting your retirement savings objectives.

Not only do you lose the opportunity to generate compound returns on the money you withdraw or borrow, but you also cease contributing to your plan when you withdraw or take a loan, putting you further behind.

However, if you're thinking about taking an early withdrawal from your 401(k), approach with caution. The 401(k) has an early withdrawal penalty due to the particular taxes of this account type. As a result, it would be worthwhile to look into other possibilities.

Questions about your 401K? Read this next: Top 3 Risks, 4 Benefits & When is the Right Time to Use Your 401K

 

2 Times When You Are Eligible to Withdraw From Your 401(k)

1. Hardship withdrawal

You may be eligible for a hardship withdrawal, which allows you to take money out of a 401(k) plan without paying the 10% early withdrawal penalty, depending on the nature of your financial need.

Total and permanent disability, some unreimbursed medical expenses, and deployment of certain military reservists are all examples of conditions that may qualify for a hardship withdrawal.

The details of what constitutes a hardship withdrawal are determined by the terms of the 401(k) plan contract. Before assuming that you are eligible for a hardship withdrawal, check with your employer.

2. 403(b) and 457 plan exemption

Similar to corporate 401(k) plans, government employers frequently offer a 403(b) or 457 plan.

Certain public safety employees are permitted to withdraw funds from their retirement plans at the age of 50, rather than at the age of 59 1/2. You should check with your employer if you believe your profession qualifies you for this exemption.

 

6 Alternatives to an Early 401(k) Withdrawal

Because of the steep penalty involved, you may feel inclined to shop around for some alternatives to early 401(k) withdrawal. Here are various alternatives you can consider.

1. Take a loan against your 401(k)

You might borrow money from their active 401(k) plan.

The money is taken out of the account and charged an interest rate, which is then returned to the account. The interest rate is usually one or two percentage points higher than the IRS's prime rate, although it can fluctuate.

A 401(k) loan may appear to be a convenient alternative right now, but it could jeopardize a person's retirement. It's simple to envision a situation in which the debt is not repaid. If the loan is not repaid, the IRS may assess a 10% penalty on the amounts given.

Additionally, contributions to a 401(k) are made with after-tax dollars. Because the money borrowed from the 401(k) is pre-tax, replacing it with money the borrower has already paid taxes on may make a 401(k) loan more expensive than it appears at first.

While this loan has a low-interest rate and is repaid to the borrower rather than a bank, it comes with several disadvantages. To begin with, taking money out of a 401(k) account stops that money from going into the stock market. A trader may miss out on the market's upswing and compound returns.

Furthermore, if a person leaves their firm before the loan is paid back, the loan must be paid back by the time you file your taxes for that year, otherwise, a penalty and income tax may be owed. Participants should proceed with caution down this path.

 

2. Withdraw from your Roth IRA

Another option is to consider taking money out of your Roth IRA. After 5 years, any money donated to a Roth IRA can be withdrawn without penalty or taxation, according to IRS guidelines.

Income taxes are paid on money that the account holder contributes to the account, unlike a 401(k). As a result, when the money is taken out, it is not taxed. (Note that this only applies to contributions, not earnings from investments.)

Taking money out of a retirement account should always be regarded as a last resort, according to common wisdom. Because most people are already behind on their retirement savings, Roth IRA funds should be explored only after all other choices have been exhausted.

 

3. Personal loan

A personal loan is another option to consider. An unsecured personal loan can be utilized for almost any personal purpose. The member can avoid a 401(k) early withdrawal penalty by taking out a personal loan and allowing all of the money put in the plan to continue to grow.

A personal loan also places the borrower on an amortized repayment plan with a set due date. Having a set payback time can help with debt repayment because it gives you a goal and shows you how far you've come over the course of the loan.

When compared to a revolving credit card, where it can be quite tempting to add to the balance even while seeking to pay it off in full, a personal loan has a defined amortization.

When charges are added to a credit card, the due date might be pushed back even more, especially if the borrower is simply paying the minimum. A personal loan, on the other hand, is a lump sum loan that is disbursed and paid back over a predetermined period.

 

4. Home equity loan

With your home as collateral, you get a better interest rate and a longer payback. It’s friendlier for your monthly budget. 

However, a home equity loan should be taken if you want to use the loan to generate more cash like starting a business. This is because you are borrowing against your home.

This loan also incurs interest. As such, it seems that the table is stacked against you when you take out a home equity loan. However, if applied in a resourceful manner, a home equity loan can be used to increase your net worth. 

 

5. Home equity line of credit

A home equity line of credit, similar to a home equity loan, allows you to borrow against your home.

The difference is that HELOC is a revolving credit, while a home equity loan is a fixed amount. This loan option is suitable for small projects and emergency expenses, as such, it is advisable to borrow as little as possible.

Instead of fixed-term repayment, you get a variable repayment and interest rate. You may opt for an interest-only repayment, but most often that comes loaded with a balloon payment, which might be hard to afford.

 

6. Zero-interest credit card

You can also opt for a zero-interest credit card.

This may give you a cushion to reduce the effects of a dire financial situation—but watch the terms. If the card's interest is "capitalized," you may be responsible for interest accrued during the offer period after the initial offer expires.

This can significantly increase your principal balance, making it even more difficult to pay off your credit card debt. As a result, if you use this type of offer to transfer debt, it's critical to pay back the sum before the due date.

 

Final word

With all of the aforementioned possibilities, it's a good idea to sit down and figure out how much each alternative will cost.

To do so, you might wish to consult a personal loan calculator and/or engage with a tax or financial counselor to determine the best course of action. In the end, it will be up to you to discover the finest alternative for your specific requirements.

Photo by Karolina Grabowska from Pexels

 

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