How 401(k) Withdrawals Work When You're Unemployed

If you find yourself unemployed and your savings are insufficient to tide you over until you land a new job, it's natural to think about whether you can draw on your 401(k) funds. (Quick recap: A 401(k) plan is an employer-sponsored savings plan that allows employees to contribute pre-tax earnings aimed at building a retirement nest egg. Contributions are often invested in securities, such as mutual funds or company stock. Interest, capital gains and dividends are allowed to grow within the plan without being taxed. Normally, money can't be withdrawn from a 401(k) until the account holder reaches age 59½. Withdrawals taken from the account before 59½ are subject to a 10% penalty, in addition to being taxed at the employee’s ordinary income tax rate. After that, withdrawals – officially known as  distributions – from 401(k) plans are taxed as ordinary income.)

Unemployment presents a series of choices for an individual who owns a 401(k). First, there's the question of whether to keep the account with the former employer or roll it over (or directly transfer it) into an individual retirement account (IRA). Handled correctly, a rollover IRA constitutes an in-kind transfer, where a lump sum from an employer-sponsored tax-deferred account is moved to an individual account. If Internal Revenue Service (IRS) guidelines are followed, the transfer is not considered a taxable event.

Taking that step might make it easier to access the funds: While you'll have to pay taxes on the withdrawal, no matter what, you might not have to  pay the 10% penalty. However, you will be subject to the rules for hardship withdrawals for IRAs (see 9 Penalty-Free IRA Withdrawals). Among permitted hardship withdrawals that don't subject you to the penalty: disability and needing to pay for health insurance or higher educational expenses. Even if you didn't leave on the best of terms, read the rest of this article before deciding whether to keep roll over your 401(k) into an IRA.

If joblessness lingers, individuals face a second question: What happens if they haven't reached 59½ and need to tap into their 401(k) to keep bills paid? There are some special options that can help unemployed workers avoid extra penalties and still gain access to some 401(k) money.

If you become unemployed in the calendar year when you turn 55 (or after that) is that you don't have to wait until age 59½ to gain access to your 401(k) money without having to pay the 10% penalty. In fact, if you still have other 401(k) money at an employer you left long ago, you will also gain access to those funds. This is not true, however, if you rolled over that money into an IRA. By the way, unlike with unemployment, it doesn't matter if you were laid off, fired or resigned.

What if you're under 55? There's another option for getting your hands on distributions without being charged the 10% penalty. Unemployed individuals can receive what are termed substantially equal periodic payments (SEPP)  from 401(k) plans under the IRS' 72(t) rule.

The payments must be distributed over a minimum period of five years or until the individual reaches age 59½, whichever is greater. There are three different (complicated) methods for calculating distributions under SEPP: required minimum distribution, amortization and annuitization. Your choice of distribution method can be modified once after an election if income needs change. Once the recipient reaches 59½, the withdrawals may cease or be ratcheted up or down without penalty. There are no further rules until required minimum distribution time at age 70½.

Payments are typically calculated based on the life expectancy of the account holder or the combined life expectancy of the plan participant and his beneficiaries. Distributions can be taken with any frequency during the year as long as withdrawals do not exceed the pre-calculated annual value. If the amount is arbitrarily modified, the 10% penalty exception is negated and you have to pay the penalties.

Bankrate has a calculator that can help you estimate what you'd withdraw, but this is one task that requires the help of a financial advisor to make sure you do it correctly.

You can also withdraw money from an IRA using the SEPP method. Discuss the best approach with an advisor before you make a final decision.

Some 401(k) plans allow for hardship withdrawals based on what the IRS terms “an immediate and heavy financial need.’’ Unlike IRA hardship withdrawals, these hardship distributions are subject to the 10% early withdrawal penalty.

Circumstances that qualify under IRS guidelines (if your company's plan permits it) include certain medical expenses, costs to purchase a principal residence, amounts needed to avoid eviction from a principal residence, and tuition or educational expenses. Individuals who receive funds from qualified retirement accounts must maintain proof that the need exists.

These withdrawals are only allowed after non-taxable loan privileges have been exhausted. Furthermore, the distribution must not exceed the amount of need. If an inpatient hospital stay creates a $5,000 deductible liability, the withdrawal must not exceed the amount of the medical expense. However, the total withdrawal may be increased to $5,500, allowing for an additional amount to cover the cost of IRS taxes or penalties.

The need is not deemed to be heavy and immediate if other resources, including assets owned by a spouse or minor children, are available.

For more on this, see When a 401(k) Hardship Withdrawal Makes Sense.

Obviously, it's anything but ideal to tap into retirement funds before you are actually retired. But sometimes, it can be unavoidable. Try to keep track of what you've spent and if you are able to find another job, make a special effort to repay what you took out into your new employer's 401(k) if there is one. If you're 50 or older – or when you reach that age – be sure to make additional "catch-up contributions" to your 401(k) and IRA. For the 2018 tax year, you can pay an additional $6,000 per year into your 401(k), for a total contribution of $24,500, and an additional $1,000, for a total of $6,500, into your IRA.

For other help during this difficult time, see How to Apply for Unemployment Insurance and Help! My Unemployment Benefits Are Running Out.