Withdrawing money from your 401(k) before age 59½ can leave you with a big bill for penalties and taxes if you don’t know what you’re doing. Here are the rules regarding 401(k)s and how to take out money without encountering any pitfalls…explained by retirement-planning specialist Nicholas Bunio, CFP, from Retirement Wealth Advisors.
A generation or two ago, retirement plans looked a lot different from what they are today. Most companies offered pensions, funded by employees (and mostly via employers) throughout their working lives, and workers were paid a percentage of their salaries from those pensions during retirement. But many employers found it difficult to fund their pensions sufficiently to meet their obligations.
That all changed just before 1980 with the advent of the 401(k), which placed responsibility for retirement savings directly into employees’ hands. It was up to them to direct a portion of each paycheck to their retirement funds…and some employers offered to match some portion of those contributions. Employees also would have to make decisions about how those funds would be invested…and would have to understand the tax rules around these new retirement vehicles.
Each year, the IRS sets a limit on how much a worker may contribute to a 401(k). For 2025, an individual under age 50 may contribute up to $23,500. Someone between ages 50 and 59 or 64 or older may contribute another $7,500, for a total of $31,000. New for 2025: If you’re 60, 61, 62 or 63 years old, you also may make a catch-up contribution totaling $11,250, but this new catch-up contribution may be made only if your employer plan allows it.
There are now two types of 401(k)—traditional and Roth. Employers offering traditional 401(k)s are required to also provide a Roth option, and there are different rules for these two versions. The difference in rules has to do not with contribution limits but with taxation.
Contributions to a traditional 401(k) are made with pretax dollars, so they reduce your taxable income. Example: If you made taxable income of $100,000 in a year and contributed $10,000 to your traditional 401(k), you wouldn’t pay taxes on that $10,000, and your taxable income would drop to $90,000 for the year. But: Years later, when you start taking distributions from a traditional 401(k), that money will be taxed at your income tax rate.
Contributions to a Roth 401(k) are made with after-tax dollars. So under the same scenario, your $10,000 contribution to a Roth 401(k) would not lower your taxable income for the year. But: When you take distributions from a Roth 401(k) years later, you would not pay taxes on the withdrawals because that money had already been taxed.
The IRS imposes a 10% 401(k) early-withdrawal penalty on funds withdrawn before age 59½. That is in addition to the tax due on the funds. In a handful of cases, people under age 59½ are exempt from the 10% penalty, specifically…
Rule of 55: If you lose or quit your job during a year in which you turn 55 or older, you may withdraw money from your 401(k) without penalty. But this isn’t a good idea in most cases because it risks depleting your retirement funds too early. Invoking the rule of 55 should be done only under the guidance of a skilled retirement advisor.
Childbirth and adoption: The IRS allows withdrawals of up to $5,000 per qualifying child to help manage expenses related to childbirth or adoption.
Death or disability: If the account owner passes away or becomes disabled, the spouse or children who inherit the fund do not face the 10% penalty on withdrawals.
Disaster recovery: Qualifying people who were directly affected by federally declared disasters may withdraw up to $22,000 distributed equally over a three-year period, but that withdrawal will be taxed. Or they may borrow from their 401(k)s at more favorable terms. Typical limits on borrowing are capped at $50,000. However, the limit on loans for people directly impacted by federally declared disasters is the lesser of $100,000 or 100% of your vested account balance. Loan repayments are usually within five years. These loans are available only if your plan sponsor allows it…and they are available only for a qualifying event if you live in a federal disaster area…suffer an economic loss due to the disaster…and take the distribution within 180 days of the date the disaster occurs.
Domestic abuse: Victims of domestic abuse may withdraw up to $10,000 or 50% of their 401(k)’s value without paying the 10% penalty.
Personal emergency: As of 2024, savers can withdraw up to $1,000 per year penalty-free to deal with unforeseeable or immediate financial needs.
Medical expenses: If you’ve spent at least 7.5% of your adjusted gross income (AGI) for the year on health care, you may make a penalty-free 401(k) withdrawal to cover additional unreimbursed medical expenses. Example: If your AGI was $100,000 and you paid $7,500 in medical bills but were facing another $1,000 in unreimbursed expenses, you could withdraw that $1,000 to pay those bills. But that $1,000 would still be treated as earned income and thus subject to tax.
Reservists: Ever since the 9/11 terror attacks, members of the military who are reservists called to 180 or more days of active duty may make penalty-free withdrawals.
Substantial equal payment: You may make penalty-free early 401(k) withdrawals by agreeing to take “substantial equal payments.” To arrive at the installment amounts and time frame, the IRS calculates your remaining life expectancy and divides your account balance over that many years. Example: If the IRS calculates that your withdrawals will be $5,000 per year for 20 years, you must take out exactly $5,000 for each of the next 20 years. If you fail to do so even at year 19, you will face the 10% penalty on every withdrawal since day one. And the exact amount means the exact amount—if you take $4,999 or $5,001 instead of $5,000, you will be subject to the retroactive penalty.
Each of these options entails considerable downside and risk, and none of them helps you avoid tax on the withdrawals as earned income. Best advice: Whenever possible, leave your 401(k) untouched until retirement, and access it only in the case of dire circumstances.
If your employer allows it, you may borrow money from your 401(k), which lets you avoid both the 10% penalty and the payment of income tax on the loan amount. But this, too, is not a perfect solution. Reasons: You must repay the loan, with interest, within five years (though, if you take a loan to buy a home, the loan repayment typically is based on the length of your mortgage). If you fail to do so, you’ll be taxed and penalized as if the transaction had been a withdrawal. And by reducing your account balance by the loan amount, you’ve diminished its investment power. Yes, you’ll be earning interest off yourself in the form of loan repayments, but these likely will be in the neighborhood of 2% to 3% lower than your investments would have made in the markets. And while you’ve avoided paying tax on the loan amount for now, you’ll still owe tax on it when you withdraw it from your 401(k) during retirement. Also, loans have restrictions on how much you can withdraw, based on your account value—the maximum is no more than half of your vested account or up to $50,000…and loans do require a quarterly minimum repayment.
If you’re still young, it almost always works better to choose a Roth 401(k). If you’ve already been investing into a traditional 401(k), consider converting it into a Roth account as early as possible. Why? Because you won’t owe income tax on the investment earnings of a Roth 401(k). By paying income tax on the money in your traditional account now when you convert it to a Roth, you’re avoiding having to pay taxes on a bigger balance (and possibly at a higher rate) when you start making withdrawals during retirement.
