Is It Better to Withdraw From a 401(k) or a Roth IRA?

Individuals sometimes face financial pressures that require accessing retirement funds sooner than planned. Making the choice to withdraw from a 401(k) or a Roth Individual Retirement Arrangement (IRA) carries financial consequences that extend beyond the immediate cash need. The rules governing each account type are distinct, and the timing and nature of a withdrawal dictate the resulting tax and penalty implications.

Tax and Penalty Rules for 401(k) Withdrawals

When you withdraw funds from a traditional 401(k), the entire amount is treated as ordinary income for that tax year. This is because contributions are made on a pre-tax basis, and the investments have grown tax-deferred. The Internal Revenue Service (IRS) requires you to pay income tax on the distribution at your current marginal tax rate, which can push you into a higher tax bracket.

Beyond ordinary income tax, a 10% early withdrawal penalty is applied to distributions taken before you reach age 59½. This penalty is an additional tax on top of the regular income tax. For example, if an individual in the 22% federal tax bracket withdraws $20,000 from their 401(k) before this age, they would owe $4,400 in income tax and an additional $2,000 as a penalty, assuming no state income tax.

The tax code provides for several exceptions to the 10% early withdrawal penalty, though income tax is still due on the withdrawn amount. One common exception is for a “separation from service.” If you leave your job during or after the year you turn 55, you can take distributions from that specific employer’s 401(k) without incurring the 10% penalty. This exception does not apply if you roll the funds over to an IRA.

Other penalty exceptions are tied to specific life events, but you should check with the 401(k) plan administrator, as some plans may not permit withdrawals for all of these reasons. Common exceptions include:

• Becoming totally and permanently disabled.
• Having a physician-certified terminal illness, defined as a condition expected to result in death within 84 months.
• Paying for unreimbursed medical expenses that exceed 7.5% of your adjusted gross income (AGI).
• Distributions for a qualified birth or adoption (up to $5,000).
• Covering unforeseeable personal or family emergency expenses (up to $1,000 per year).
• Being affected by a federally declared disaster (up to $22,000).
• Being a victim of domestic abuse, allowing a withdrawal of the lesser of $10,000 or 50% of the vested account balance.

Tax and Penalty Rules for Roth IRA Withdrawals

Roth IRAs operate under a different set of rules because contributions are made with after-tax dollars. The IRS dictates that all withdrawals from a Roth IRA are considered a return of your direct contributions first. Since you already paid income tax on this money, you can withdraw your contributions at any time, at any age, for any reason, completely free of both taxes and penalties.

Once you have withdrawn all of your contributions, subsequent withdrawals are sourced from converted amounts, if any, and then finally from investment earnings. It is only when you begin to tap into the earnings portion of your account that taxes and penalties may apply.

For a withdrawal of earnings to be considered “qualified,” and therefore tax- and penalty-free, two conditions must be met. First, you must be at least 59½ years old. Second, you must have first funded any Roth IRA at least five years prior. This five-year clock starts on January 1 of the tax year for which your first contribution was made.

If a withdrawal of earnings does not meet the criteria for a qualified distribution, it is subject to both ordinary income tax and the 10% early withdrawal penalty. However, exceptions can waive the 10% penalty on an early withdrawal of earnings, though you would still owe income tax. Most of the exceptions available for 401(k)s also apply to IRAs, but IRAs offer unique penalty waivers for using funds for a first-time home purchase (up to $10,000) or for qualified higher education expenses.

Key Factors for Deciding Which Account to Use

Immediate Tax Impact

The most direct financial consequence of your withdrawal is the immediate tax bill. A withdrawal from a Roth IRA that only taps into your contributions is completely tax-free. In contrast, any withdrawal from a traditional 401(k) is fully taxable as ordinary income, which significantly reduces the net amount you receive.

Amount of Funds Needed

The total amount of money you need to access is a primary driver in this decision. You should first determine the total amount of your direct contributions to your Roth IRA. If the cash you need is less than or equal to this amount, the Roth IRA is almost always the better source. If the amount you need exceeds your Roth IRA contributions, you will have to dip into earnings, which could trigger taxes and penalties.

Penalty Avoidance

Your reason for needing the funds is a significant factor because of the various penalty exceptions available for each account type. You must compare your specific situation to the list of IRS-approved exceptions. For instance, if you are 56 and were laid off, the “separation from service” rule allows for penalty-free withdrawals from that company’s 401(k). Conversely, if you need $10,000 for a down payment on your first home, the Roth IRA provides a specific penalty exception for this purpose.

Future Tax Considerations

Withdrawing from retirement accounts has long-term consequences for your financial future. When you take money from a traditional 401(k), you are reducing a pool of tax-deferred assets, while a Roth IRA withdrawal depletes a source of future tax-free growth. Preserving the Roth IRA is often advantageous, especially if you anticipate being in a higher tax bracket in retirement, as its tax-free growth is a powerful wealth-building tool.

The Process of Making a Withdrawal

For a 401(k) Withdrawal

To initiate a withdrawal from your 401(k), you must contact the plan administrator, which is typically your employer’s human resources department or the financial institution managing the plan. You will need to request and complete the appropriate distribution forms. These forms require personal information, the amount you wish to withdraw, and the reason for the withdrawal to determine if a penalty exception applies.

A critical part of the process involves tax withholding, as the plan administrator is required to withhold a mandatory 20% for federal income taxes on most early withdrawals. You can use Form W-4P, “Withholding Certificate for Pension or Annuity Payments,” to specify if you want more than the mandatory 20% withheld. After submitting the paperwork, it can take several business days to a few weeks to receive the funds.

For a Roth IRA Withdrawal

The process for withdrawing from a Roth IRA is handled directly with the financial institution that holds your account. Most institutions allow you to initiate a withdrawal request online, though some may require you to call a representative or submit a form. You will need to provide your account number, specify the amount you wish to withdraw, and direct where the funds should be sent.

If you are withdrawing earnings that are not qualified, you will have the option to have taxes withheld. The timeline for receiving funds from a Roth IRA is usually quick, often within a few business days for an electronic transfer to a linked bank account.