February 24, 2023
You’ve run into legal trouble, and you’re struggling to pay the various fees associated with that situation. Suddenly, you’ve remembered that you have a 401k that you’ve been contributing to for several years. Can those funds be withdrawn to help you pay your legal fees? Let’s examine how 401k withdrawals work and whether that is the best option.
The first question is if you have the privilege or right to withdraw funds from your 401k. The answer to that question is you can withdraw funds, but don’t consider it as free money. There are rules for how funds can be withdrawn from 401k plans, and many people are surprised by those rules.
Some companies automatically enroll their employees in the company 401k program. Employees can opt out of the plan when they are signed up in this manner. Other employers allow workers to decide if and when they want to participate.
Often, the plan sponsor is the one who must educate the employees on how their 401k plan works. When employees begin contributing, they get a good bit of information. However, the information tends to dwindle when it comes to changing jobs, retiring, or withdrawing the money that has been invested.
Each 401k plan has rules regarding withdrawals. Often, that means you can withdraw some of the money, but you can’t simply cash out the entire thing. The two most common ways to withdraw money from a 401k are through a loan against the balance or a hardship withdrawal.
A hardship withdrawal of your 401k is a lump-sum withdrawal made based on financial need that doesn’t need to be repaid to the plan. A hardship withdrawal must meet specific criteria, or you will face an early withdrawal penalty. Taxes must be paid on any amount that you withdraw from your plan.
Another instance that employees can withdraw a lump sum from their 401k is in the event they have adoption or birth expenses to pay. Section 113 of the Setting Every Community Up for Retirement Enhancement (SECURE) Act allows new parents to withdraw a maximum of $5,000 from their 401k without penalty to pay those birth or adoption expenses. The SECURE Act was signed into law in December 2019.
Plan participants can sometimes get a loan from their 401k plans. These loans are usually paid back over time using paycheck deferrals. The loans are capped at a specified percentage of the total 401k balance. The IRS allows up to 50% or a maximum of $50,000 of vested funds, whichever one is less.
If your 401k plan allows you to take out a loan, those funds can be withdrawn tax-free. These loans must be paid back into your 401k plan. The loans will enable you to borrow from yourself and pay the interest and principal back over time.
When you leave your employer or retire, your withdrawal options aren’t as limited. You can take lump-sum distributions to your total vested balance without penalty from a previous employer’s 401k plan. When you place a distribution request, in this case, the plan sponsor will send a check to you, and your account will be closed.
If your 401k is a traditional pre-tax 401k plan, the sponsors will withhold taxes from the balance before they send you a check. If you have a Roth 401k, no taxes are withheld from your balance. However, there are tax penalties with either kind if you don’t meet the age criteria.
The greatest benefit of a lump sum distribution from the 401k plan is accessing all the retirement savings at once. Your money isn’t restricted, so you can use it any way you need to.
Distributions to a 401k are tax-deferred, meaning your plan isn’t subject to yearly capital gains taxes. When a lump sum distribution is made, you can no longer earn on a tax-deferred basis, leading to lower investment returns.
You may also have tax liabilities in the year you receive your distribution because the withholdings on your pre-tax balances may not have been enough.
If you cash out your entire 401k, you receive what is left after taxes and penalties. Penalties are assessed if you are younger than 59.5 when you cash out the plan. The early withdrawal penalty is 10% of your vested balance. So, for a hypothetical example with easy math, if you are 58 years old, you have a 401k balance of $100,000, and you are in the 25% tax bracket, after taxes and penalties, you would receive $65,000.
If you choose to withdraw your 401k before retirement, there are consequences. We’ve already touched on some of them, but let’s consider them more in-depth.
While the consequences of an early withdrawal present a financial obstacle to using your 401k, there are possible ways to mitigate those consequences.
Other exceptions could negate the 10% penalty if making an early 401k withdrawal. For example:
There is a provision in the Secure 2.0 Act, signed into law at the end of 2022, allowing special emergency distributions of up to $1,000 per year starting in 2024.
Whether you can make a hardship withdrawal is generally at the plan administrator’s discretion. You may need to explain why you can’t obtain the money another way. Typically, you can withdraw your contributions and those that match them, but not the gains. You could have to pay income taxes and the 10% penalty on a hardship distribution.
Before withdrawing early from your 401k, ensure you understand the possible consequences. Discuss all the payment options with your attorney before you use an early withdrawal for legal fees. If you need legal advice, contact the attorneys at the Aberdeen Law Firm with any questions.
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