A 401k plan is a special kind of retirement savings plan funded through contributions from payroll prior to tax deduction, and 401k withdrawal rules set out the circumstances under which you can take money out of your plan. The name of the plan refers to section 401k of the Internal Revenue Code, under which these contributions are permitted. Most programs provide a range of investment options, in mutual funds or in other types of asset with varying levels of risk.
Starting a 401k plan is obviously very advantageous in terms of the tax benefits it provides, but it is a very attractive option for other reasons as well. Although employers are not obliged to contribute to the funds of their employees, many do offer to match contributions, as part of a package of employment benefits. This greatly increases the final retirement amount available to the investor. In addition, the growth of the fund is tax deferred, and employees have a great deal of control over the types of asset in which their funds are invested, according to how risk averse they are. Another benefit is that the plans are portable, that is, employees can take at least their own portion of the plan with them when they move companies.
The reason that 401k plans were created was to ensure employees had reasonable financial provision for their later years. Ideally, therefore, the money in the fund should be left alone till retirement. However, the government recognizes that in the real world, there are going to be times when you have a desperate need for a cash sum and you have no other option but to draw on your retirement savings. The government has therefore drawn up 401k withdrawal rules, to clarify the circumstances under which investors may be able to legally withdraw their funds.
The overriding principles of 401k withdrawals are first and foremost that the sums withdrawn from them are classed as income, and thus are subject to tax. The reason for this is that the original contributions were made on pretax income, and the investment growth is tax deferred. Second, if the employee makes the withdrawal before reaching the age of 59 and a half, this is classed as early withdrawal and is subject to stringent hardship rules. There are two kinds of 401k hardship withdrawal: financial and non financial.
A 401k hardship withdrawal of the financial type can be made if you find yourself subject to an urgent and immediate financial emergency, and you can demonstrate that you have no other way of meeting this commitment. Such emergencies could include imminent eviction from, or foreclosure on, your primary residence, or medical expenses which will not be refunded. An emergency could also include a simple inability to make ends meet on your current available income. You need to specify the precise amount which is required, for instance to prevent home foreclosure, and the withdrawal may not exceed this amount.
A 401k hardship withdrawal of this type is subject not only to the 401k early withdrawal tax, but to the 401k withdrawal penalty as well. Amounts withdrawn cannot be returned to the fund at a later date. Once withdrawn, the money has to be used for specified purposes, mainly to meet the emergencies which were conditions of the withdrawal being allowed, such as preventing home foreclosure or meeting emergency medical expenses. However, it can also be used for college expenses for a child, or as a 401k withdrawal for home purchase.
A 401k hardship withdrawal for non financial reasons is still subject to tax, but not to the 10 percent penalty. You can qualify for early 401k withdrawal without penalty if you meet certain conditions, one of which is a complete and permanent disability. You can also qualify if the amount you owe for your medical expenses comes to more than 7.5 percent of your gross income, or if a court has directed that you hand over the money to a divorced spouse, or to a child or other dependant. In addition, you can withdraw your funds without penalty if you leave your employment permanently in the year you turn 55 or later, whether you are terminated or laid off, resign or take early retirement.
Another way you can take a 401k withdrawal without penalty is if you immediately transfer the cash into another qualifying retirement plan, such as IRA. This is called a rollover and it must take place within 60 days of withdrawing. You can do this without penalty because the money is still serving as provision for your retirement. Payments from the fund made to your estate or your beneficiaries after your death are also not subject to penalty.
One possible way in which you withdraw your 401k money without either tax or penalty is by taking out a 401k loan, that is, borrowing against the funds in your plan. Employers are not obliged to offer this facility, and those who do will usually impose restrictions, including a minimum balance such as $1,000. Generally, you can take up to 50 percent of your vested account balance (the vested balance is the percentage to which you have built up a permanent entitlement, even if you leave the company) up to a maximum of $50,000. It must be repaid within 5 years unless it is for a home purchase, in which case a longer period is allowed. Interest is payable, but as it goes back into your fund it still benefits you, unlike paying interest to a bank.
Once you pass the age of 59 and a half, your 401k withdrawals count as retirement benefits and so are not subject to penalty, though they are still taxed as part of your normal income. You are not required to make any withdrawals, or distributions, until you reach 70 and a half, after which you have to take at least the required minimum by April 1st of the following year at the latest, and then annually by December 31st of each year. You should therefore take your first distribution earlier than April, to avoid paying tax on two in the same year.
There may sometimes be no alternative to early withdrawals from 401k funds. However, they should be avoided if at all possible. Not only do they attract penalties, but you lose out on all the growth which the amount would have generated. Withdrawing is a major decision and you should always discuss it with a financial adviser, to ensure you understand the 401k withdrawal rules, and that you have explored all the options.