A 401(k) is an employer-sponsored Retirement savings plan. It allows employees to contribute a portion of their pre-tax salary to a Retirement account. Contributions are tax-deferred, meaning they are not taxed until withdrawn. Employers may also match a portion of the employee's contributions (can be subject to a vesting schedule unless safe harbor or SIMPLE). For the year 2023, the contribution limit for employee contributions to a 401(k) is $22,500. However, when combined with employer contributions, the total contribution limit for married couple can reach $66,000. Individuals who are 50 years or older are eligible for an additional catch-up contribution of $7,500, allowing them to contribute up to $30,000 as employees.
Generally, the minimum age for penalty-free withdrawals from a 401(k) is 59½ years old. If you withdraw funds before this age, then you may be subject to a 10% early withdrawal penalty in addition to income taxes. However, there are a few exceptions that may allow you to avoid the penalty. Some common exceptions include:
1. Separation from service: If you leave your job in or after the year you turn 55 (or 50 for certain public safety employees), then you may be able to withdraw funds penalty-free from the 401(k) associated with that job.
2. Substantially Equal Periodic Payments (SEPP): You can set up a series of substantially equal periodic payments based on your life expectancy, which allows you to withdraw funds penalty-free before the age of 59½. However, you must commit to taking these payments for at least five years or until you reach age 59½, whichever is longer.
3. Hardship withdrawals: In cases of financial hardship, such as medical expenses or preventing eviction from your primary residence, you may be eligible for a hardship withdrawal. However, this option should be used as a last resort, as it can have long-term consequences on your retirement savings.
4. Homebuyers: First option is to take a loan from your 401(k) account. This is preferable as it allows you to avoid the 10% early withdrawal penalty and the withdrawn amount is not taxed as income. The maximum amount you can borrow is $50,000. However, you need to repay the loan with interest, usually between 1-2%, and you won't be able to make additional contributions to your 401(k) until the loan is fully repaid. This means your employer won't match any contributions during this period. If you fail to repay the loan by the due date, then it will be considered a withdrawal by the IRS, subjecting you to income tax and the 10% early withdrawal penalty. The second option is to withdraw up to $10,000 (taxable) if qualify as a first-time homebuyer.