Can I Withdraw Money from My 401k to Pay My Legal Fees? 

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 Can those funds be withdrawn to help you pay your legal fees?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.

Ways to Withdraw Money from Your 401k in Washington

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 There are rules for how funds can be withdrawn from 401k plans, and many people are surprised by those rules.

Lump-Sum Withdrawal Options While Still Employed

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.

Hardship Withdrawals

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.

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401k Loans

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.

Options When You Leave an Employer

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.

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Special Considerations When Making Withdrawals

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.

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How Much Can You Get If You Cash Out Your 401k in Washington?

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.

Consequences of 401k Early Withdrawal

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.

1. Taxes will be withheld. The IRS has a set amount that must be withheld from a 401k early withdrawal. The typical automatic withholding amount is 20%. So, if you’re making a withdrawal at age 40, you may only get $8,000 of a $10,000 withdrawal. Of course, you may get some of the withholding back as a tax refund if your withholding is more than your tax liability.
2. The IRS will assess penalties. The legal age to withdraw your 401k is 59 ½, and if you choose to withdraw before that time, the IRS will assess a 10% early distribution penalty. That penalty is on top of paying the ordinary taxes on the money. So, with that same $10,000 example, 20% was assessed in withheld taxes reducing it to $8,000, and there is an additional 10% early withdrawal penalty which reduces the amount by another $1,000, leaving you with $7,000.
3. You could lock in investment losses. If the market is down when you withdraw, it can impact the kind of rebound you will have when the market rebounds. That means you would be looking at less money later.

Considerations If You’re Taking an Early Withdrawal in Washington

While the consequences of an early withdrawal present a financial obstacle to using your 401k, there are possible ways to mitigate those consequences.

1. Find out if you qualify for an exception to the 10% early withdrawal penalty. The IRS will often waive that tax penalty if one of the following applies to you:
   1. You receive “substantially equal periodic” payments. That means you have agreed to take the amount from your 401k in payments at least once per year. These payments begin after you stop working and must stay the same for at least five years or until you are 59 ½ (whichever happens last). There are several rules associated with this option, so check with a financial advisor before making the decision.
   2. You leave the job. This exception only applies if it’s the year you turn 55 or later unless you work in federal law enforcement, firefighting (federal), customs, border protection, or air traffic control. For those jobs, it must be the year you turn 50.
   3. You must divide your 401k in a divorce. If the court orders you to cash out a 401k to split it with your ex-spouse, that withdrawal could be penalty-free.

Other exceptions could negate the 10% penalty if making an early 401k withdrawal. For example:

• You become or already are disabled.
• You rolled the account over to another plan.
• The payments were made to a beneficiary or your estate after your death.
• You adopted or gave birth to a child (there is a $5,000 limit per account in this case.)
• The money was used to pay an IRS levy.
• You were a victim of a disaster that resulted in the IRS granting relief.
• You were auto-enrolled or over-contributed to a 401k and want out of the plan.
• You were a military reservist that was called into active duty.

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.

1. See if you meet the qualifications for a hardship withdrawal. These withdrawals are allowed due to “immediate and heavy financial need.” Typically, these withdrawals aren’t subject to a penalty. To qualify for a hardship withdrawal, you must generally need to pay one of the following:
   1. Medical bills for you, your dependents, or your spouse
   2. Money for buying a house (not making mortgage payments)
   3. College tuition, room, board, and fees for you, your spouse, or your dependents.
   4. Money to avoid eviction or foreclosure
   5. Funeral expenses
   6. Specific costs to repair damage to your home

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.

1. Think about converting your 401k to an IRA. Individual retirement accounts have different withdrawal rules than 401k. You could avoid withdrawal penalties if you convert your 401k to an IRA before the withdrawal.
2. Take out the minimum amount you could need when you cash out the 401k. Any withdrawal has the potential to have penalties and taxes. So, you should only withdraw in emergencies and take the least amount you can get by with.

Closing Thoughts

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.

Related Content: Does a Spouse Get Half of the 401K in a Bellevue Divorce?

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