Though your 401(k) is intended to save for retirement, you might be tempted to try to tap into your nest egg early, whether it's for financial emergencies or a little extra spending money. However, the Internal Revenue Service has restrictions on when you can access the money in your account, and it applies penalties to early distributions.
When You Can Withdraw Money From Your 401(k)
If you're over 59 1/2, you can take out as much money as you want from your 401(k) plan without penalty, whenever you want. If you're under 59 1/2, your options are more limited: you can only withdraw money if you've left your company, you are disabled, your 401(k) plan terminates without a successor plan or you have a financial hardship. Worse, even if you can get some of your 401(k) money out, you'll owe an early withdrawal penalty unless an exception applies.
Hardship distributions refer to special times when you're allowed to take money out of your 401(k) for an immediate and heavy financial need. These distributions are limited to the amount necessary to take care of the need. Though permitted by the IRS, it is up to each 401(k) plan to decide whether to permit hardship distributions and, if it does permit them, to set the criteria for what constitutes a hardship distribution. For example, medical expenses, tuition payments, funeral costs and the purchase of a primary residence could constitute financial hardships under the IRS definitions, but your plan might only allow hardship distributions for medical expenses.
If you take money out of your 401(k) before age 59 1/2, you pay an extra 10 percent tax penalty unless you qualify for an exemption. Exemptions include distributions for medical expenses that exceed 10 percent of your adjusted gross income; distributions that satisfy a qualified domestic relations order; distributions taken while you are permanently disabled; a series of substantially equal distributions taken over your life expectancy; distributions taken to satisfy an IRS levy on your 401(k) plan; or distributions that meet the criteria for qualified reservist distributions, which occur when you have been called to active duty. There's no exemption for hardship distributions in general, so unless a specific exemption applies, you still pay the penalty. For example, even though your plan might permit you to take out out money to pay for tuition, there's no exemption from the penalty for educational expenses.
Another downside to raiding your 401(k) plan before retirement is you can't add extra in future years to make up for what you took out. The only way to avoid losing the tax-sheltered growth is to roll over the money within 60 days to another qualified retirement plan. If you took a hardship distribution or are taking a series of substantially equal distributions, you're not allowed to roll over the money -- once it's out, it's out for good. Alternatively, some people choose to take a 401(k) loan instead of a distribution. You can borrow up to half your 401(k) balance or $50,000, whichever is smaller, and repay it over five years (or more, if you're using the loan to buy a primary residence).