Withdrawals and loans can be taken out of a 401(k) before retirement, but the money may be subject to penalties, conditions, and taxes.
It is quite common that 401(k) funds are needed before retirement, even though the IRS wants you to wait until you’re 59 ½, and will generally want to levy a 10% penalty on any premature withdrawals.
Most plans allow employees to take non-taxed loans out on their balance, which may stunt the growth of the account which was intended for retirement, but if the funds are paid back on-schedule, as stipulated in the plan’s loan agreement, the employee can get back on track quickly.
Loans must normally be repaid within a year or two but the schedule can be as long as 5 years. Loans which are not repaid on-time are considered distributions. If a withdrawal is treated as a distribution, and the employee is younger than 59 ½, it is usually going to subject to income taxes and a 10% IRS early-withdrawal penalty.
It is a common misunderstanding that exemptions from this penalty can be made for education expenses and first-time homebuyers, but these exemptions are for IRAs only. Certain exemptions do exist for early 401(k) distributions, such as qualified medical expenses, court-ordered distributions in divorce proceedings (QDROs), distributions to the family of military personnel called to active duty, and 72(t) distributions of substantially equal payments.
72(t) distributions are based on life expectancy tables and annuity rates on the entire balance of the account, and must be taken for the longer of 5 years or until the participant reaches age 59 ½. The exemptions that are reserved for IRAs (such as education expenses and first-time homebuyers) can actually be taken advantage of If the 401(k) will allow an in-service distribution to an IRA account.
Some plans do, some plans don’t. The above actually only covers what is stipulated by law. There is also a provision that plans can allow hardship withdrawals for other reasons, but they are not required to. The same goes for non-hardship early withdrawals.
If an employee can prove a need and a lack of other resources, distributions can possibly be made to avoid foreclosure, pay for education, repair a home, pay medical expenses, and other reasons, but, again, this is at the discretion of the plan administrator.
Such distributions may still be subject to a 10% penalty, and it may also mean that the plan will not permit you to contribute to it at all for 12 months, among other possible consequences.
As a general rule, it’s not a good idea to take money out of your 401(k) before you retire, simply because that money was initially set aside to fund your retirement. The compounding effects of that lump sum are probably going to vastly outweigh the benefit you get from taking it as a distribution now.