When you’ve been diligently contributing hard-earned money to your employer-sponsored 401(k) retirement plan for decades, it can be tempting to withdraw some of the funds for expenses that may seem more important or urgent than a retirement that’s still years away. In some dire situations, withdrawing from retirement savings is certainly justifiable and may be allowable as a hardship withdrawal. However, there are also situations where the potential damage to your financial security in retirement isn’t worth it. Understanding the consequences of a 401(k) early withdrawal penalty can help you determine if it’s the right decision for you.
But first, it’s important to understand the basics of 401(k) plans, 401(k) withdrawal rules, and why tapping into a 401(k) plan should generally be a last resort. It will also highlight the importance of financial planning in helping to achieve both short-term and long-term security as well as building wealth.
How 401(k) plans work
An employer-sponsored 401(k) retirement plan offers the opportunity to grow invested contributions tax-free with pre-tax income that typically comes directly out of your paycheck. You may get to choose the percentage of income to contribute, though Vanguard reported that 60% of its plans now require at least 4%.1 Often, your employer may match a certain percentage of your contributions which is vested after a certain amount of employment time. The most common employer match for plans is $0.50 for each dollar of the first 6% of compensation you contribute. The IRS sets contribution limits each year. In 2025, an employee can contribute up to $23,500 into their 401(k) plan and employees ages 60 to 63 can make a catch-up contribution of up to $11,250 to their plan.
Qualified distributions from a traditional 401(k) plan can occur after you reach age 59 ½. Annual required minimum distributions (RMDs) must begin at age 73 unless you’re working. Each 401(k) plan has its own rules about loans and early distributions. Some plans allow you to take a loan — but if you don’t pay the money back, typically with interest added at a bit more than the prime rate, then it may be considered a distribution and taxed accordingly. There may also be a 10% tax penalty if it’s an early withdrawal before you’re aged 59 ½ or if you don’t qualify for an IRS exception.2 Some 401(k) plans could require that you pay back the loan if you stop working for the employer. Hardship withdrawals could be permissible without penalty according to your plan’s allowances and IRS rules, generally when there’s “an immediate and heavy financial need.”
When you should use 401(k) plan funds
- You’re 59 ½ or older and retired: When you turn 59 ½, withdrawals from a 401(k) plan are taxed as income but do not incur a 10% early withdrawal penalty. However, being eligible to withdraw at this age or older doesn’t necessarily mean it’s the right time. If you’re still working or have other income streams like a pension or Social Security, delaying 401(k) withdrawals could allow your funds to grow and last longer. With the U.S. life expectancy in 2024 at 79 ¼ years, you may need your funds to last another 20 years or more.3 Remember, a 401(k) plan is designed to support you financially throughout your entire retirement.
- You won’t incur a penalty: If you need a loan that you can repay within five years (plus interest), you may be able to borrow up to 50% of your 401(k) balance, up to $50,000. Taxes and penalties won’t apply if you repay the funds. However, you’ll miss potential gains from the invested funds, which you’ll essentially replace with the interest payment. Additionally, if your circumstances change and you can’t repay the loan, it could cost you much more when you add up the lost gains, taxes, and penalties.
- You don’t have another recourse: There may be times when circumstances are beyond your control, such as a pandemic, natural disaster, medical costs, or death, cause financial hardship. Without sufficient emergency savings, insurance, or access to loans, it may be necessary to check with the 401(k) plan administrator to see if a hardship withdrawal is allowable. Both the plan and the IRS typically have rules regarding what qualifies as a hardship, the amount that can be withdrawn, and how taxes will apply. Unlike a 401(k) loan, a hardship withdrawal does not require repayment.
When you should NOT use 401(k) plan funds
- For discretionary expenses: Saving for big expenses that are not essential to your everyday living is more practical than possibly jeopardizing your financial security in retirement. Maybe there’s an opportunity to take a pricey family vacation, an occasion that warrants an expensive piece of jewelry, or a newly available luxury car. Consider the potential losses to your compounding 401(k) funds if you withdraw money for these types of expenses. Pay attention instead to your cash flow and plan for discretionary expenses.
- To pay off debt: The penalties or taxes you might pay to withdraw 401(k) funds could exceed the interest savings on your loan, credit card, or mortgage debt. Even if you want to be debt-free or own your house outright, withdrawing from your 401(k) plan to pay down debt could reduce the compounded return potential of your investments, and result in long-term financial effects. Calculate the financial benefits and losses carefully and resist acting on impulse or emotion.
- When separating from an employer: Regardless of whether it’s your choice to leave the employer who sponsors your 401(k) plan, cashing out the funds is likely not a good option given the penalty and tax consequences. In addition to the income tax you’ll pay on the cash withdrawal plus the 10% early withdrawal penalty, an employer may hold onto 20% of your account balance to prepay the taxes you’ll owe. For a balance of $7,000 or more, it might be more beneficial to leave the money in the plan or roll it over to another qualifying account such as an individual retirement account (IRA) or new employer 401(k) plan. Explore your account options, including any fees and tax implications before making a decision.
- Because you don’t have a financial plan: Less than half of Americans (44%) know how much money they need to save for their retirement.4 But a financial plan is about more than retirement savings. Financial planning helps you set goals, develop a cash flow strategy, and make educated choices for managing risk, borrowing money, and investing. If you want to have control of your financial future, it’s important to have a realistic view of your finances and financial behavior to help make confident and prudent decisions. Having a financial plan could prevent you from endangering your long-term financial security by misusing your 401(k) funds.
How we can help
Among those who work with a financial advisor In the U.S., 80% believe they are better prepared for retirement and 71% feel more confident about their financial situation.4 Mercer Advisors collaborates with our clients to create a comprehensive financial plan that can help with preparing for significant life events, such as home buying, funding education, or retiring comfortably. We can also help you with minimizing taxes and managing your estate planning. All of which help with achieving financial security and building wealth.
If you want to find out more about financial planning as well as what you should or shouldn’t do with your 401(k) funds, let’s talk.
- “How America Saves Report 2024,” Vanguard Institutional, June 2024.
- “Retirement topics – Exceptions to tax on early distributions,” IRS, 2024.
- “U.S. Life Expectancy 1950-2024,” MacroTrends, Nov. 5, 2024.
- “Financial Advisor Statistics: Only 1 in 4 Americans Seek Guidance,” Worldmetrics.org, July 23, 2024.
