401b Withdrawal Rules: What You Need to Know Before Taking Money Out

Withdrawing money from a 401(b) involves factors like age restrictions, penalties, tax implications, and special exemptions. Understanding when withdrawals are allowed and how they affect your finances is essential before making any decisions.

Minimum Age Requirement

Access to 401(b) funds is generally restricted until age 59½. Withdrawals after this age avoid early withdrawal penalties but remain subject to income tax.

For those retiring or leaving a job at 55 or older, the IRS allows penalty-free withdrawals under the “Rule of 55.” This applies only to the most recent employer’s 401(b) and does not extend to previous accounts or IRAs.

Withdrawals can affect Social Security taxation. If distributions increase total income beyond certain thresholds, up to 85% of Social Security benefits may become taxable. Timing withdrawals strategically can help minimize tax liability.

Early Withdrawal Penalties

Withdrawing funds before 59½ typically incurs a 10% penalty plus regular income taxes. Some exceptions allow penalty-free withdrawals.

Individuals who become permanently disabled can withdraw without penalty. Another exemption applies to unreimbursed medical expenses exceeding 7.5% of adjusted gross income.

Unlike IRAs, 401(b) plans do not permit penalty-free withdrawals for education expenses. Those needing funds for tuition may face penalties unless another exemption applies.

Tax Liabilities

401(b) withdrawals are taxed as ordinary income, as contributions were made pre-tax. The tax rate depends on the account holder’s income bracket. For instance, a $10,000 withdrawal for someone in the 22% tax bracket results in $2,200 in federal taxes. State taxes may also apply.

Large withdrawals in a single year can push an individual into a higher tax bracket. Spreading distributions over multiple years or using strategies like Roth conversions can help manage tax liability.

The IRS requires a default 20% tax withholding on lump-sum distributions. If too little is withheld, a large tax bill may arise at filing time. Excess withholding means the government holds more than necessary until a refund is issued.

Hardship Withdrawal Criteria

A hardship withdrawal allows access to 401(b) funds in cases of immediate financial need but comes with strict conditions. Unlike loans, hardship withdrawals do not require repayment, though they are still subject to income tax.

To qualify, individuals must demonstrate a lack of alternative resources. Common approved reasons include medical expenses, preventing eviction or foreclosure, funeral costs, and home repairs due to natural disasters. Documentation is typically required, and employers may impose additional restrictions.

Required Minimum Distributions

Once account holders reach a certain age, they must begin taking required minimum distributions (RMDs). The SECURE 2.0 Act raised the RMD age from 70½ to 73, with a further increase to 75 set for 2033.

The IRS determines RMD amounts based on the previous year’s account balance and life expectancy. Failing to take the full RMD results in a penalty—25% of the shortfall, reduced to 10% if corrected in time.

Roth 401(b) accounts are subject to RMDs, unlike Roth IRAs. Rolling funds into a Roth IRA can eliminate this requirement.

Rollover Considerations

When leaving an employer or retiring, individuals can roll over their 401(b) funds into another retirement account. Options include a traditional IRA, Roth IRA, or a new employer’s plan, each with different tax implications.

A direct rollover to a traditional IRA preserves tax deferral, avoiding immediate taxation. Rolling into a Roth IRA, however, triggers a taxable event, as pre-tax contributions and earnings become subject to income tax in the year of conversion. This strategy may benefit those expecting to be in a higher tax bracket later.

Employer-sponsored plans may offer lower fees or unique investment options, making a rollover into a new 401(b) worth considering for those changing jobs.