Facing Financial Stress? Is Your 401(k) A Lifeline, Or A Risk?

For many Americans, their largest single source of savings isn’t a checking account or savings account — it’s their employer-sponsored retirement plan. Yet it’s also one of the most difficult accounts to access. That’s by design. Qualified defined contribution plans like 401(k)s come with rules, restrictions and potential tax penalties that make early withdrawals challenging.

When facing a financial emergency, accessing money in a 401(k) plan can feel a bit like being stranded at sea: surrounded by water, yet unable to take a drink. Your money is there, it’s just not designed to be accessed today.

What’s less discussed is why these restrictions exist in the first place — and what real options exist if you need to access those funds before retirement.

Why 401(k) Withdrawals Are Restricted

The IRS sets most of the rules around when and how you can take money out of your 401(k). The logic is simple: early withdrawals can undermine your future financial security. Taking money out today means losing both the funds themselves and the future growth those funds could generate through compounding and market participation.

To encourage long-term saving, the IRS offers a major trade-off: your 401(k) investments can grow tax-deferred for decades. In return, the system discourages early access through taxes and penalties. In short, the restrictions are there to help keep your retirement assets working for their intended purpose: providing income later in life.

Types Of 401(k) Withdrawals

Before exploring withdrawal options, remember two key rules:

• You must have a qualifying reason to take money out early.
• Your employer’s plan must allow that type of withdrawal.

Employers can customize plan rules, so even if an option is permitted under IRS law, it may not be available in your plan. If it isn’t, you can ask whether your employer would consider adding it.

Tax Considerations

Because most 401(k) contributions are made on a pre-tax basis, or aren’t taxed on their way into the plan, taxes are usually a consideration when withdrawing funds. Generally, a distribution taken in cash, or not rolled over to an IRA or another employer-sponsored retirement plan, will be treated as ordinary income by the IRS. However, that’s not the only tax consideration to keep in mind. A few other tax-related topics include:

• Capital gains myth – 401(k) withdrawals are taxed as income, not as capital gains; this is a common misconception.
• Tax withholding – When you take a cash distribution (not a rollover), plan administrators generally withhold 20% as a prepayment for federal income tax.
• State income taxes – Some states tax withdrawals from retirement plans, while others don’t.

In-Service Withdrawals

Some plans allow “in-service” withdrawals while you’re still employed — often for those nearing retirement age. Withdrawn funds are taxed as ordinary income and, if you’re under age 59 ½, may also trigger a 10% early withdrawal penalty.

Hardship Withdrawals

Hardship withdrawals are designed for specific financial emergencies, can only be made if the distribution is because of an immediate and heavy financial need, and are limited to the amount necessary to satisfy that financial need.

Qualifying expenses include:

• Expenses for (or necessary to obtain) medical care for the employee, the employee’s spouse, the employee’s dependents or a primary beneficiary under the plan
• Expenses directly related to the purchase of a principal residence for the employee (excluding mortgage payments)
• Burial or funeral expenses for the employee’s deceased parent, spouse, children, dependents or primary beneficiary under the plan
• Payment of tuition, related educational fees, and room and board expenses for up to the next 12 months of post-secondary education for the employee, the employee’s spouse, the employee’s dependents or a primary beneficiary under the plan
• Expenses relating to the repair of damage to the employee’s principal residence
• Expenses and losses incurred by the employee as a result of a disaster

While hardship withdrawals make funds accessible, they’re still taxable as income and may incur the 10% penalty if you’re under age 59 ½ — unless you qualify for an exemption.

Loans

80% of 401(k) plans allow participants to borrow from their account[1] — typically up to the lesser of 50% of your vested balance or $50,000. Participants then repay the loan (with interest) within five years. A loan taken for the purpose of purchasing the employee’s principal residence may be able to be paid back over a period of more than five years.

The key risk? If you leave your job and can’t repay the remaining balance quickly, it may be treated as a taxable distribution — plus you’ll be penalized the additional 10% if you’re under age 59 ½.

Separation From Service Distributions

When you leave an employer, you can take a lump-sum distribution — but doing so often triggers taxes and penalties and halts tax-deferred growth.

A better move for many is a rollover to an IRA or your new employer’s plan. A rollover keeps your assets invested and tax-deferred while preserving flexibility and continuity in your retirement strategy.

Qualified Early Withdrawals

Certain early withdrawals can avoid the 10% penalty if you meet one of these specific IRS conditions:

• You separate from service in or after the year you turn 55 (age 50 for certain public employees)
• You take “substantially equal periodic payments” over your life expectancy
• You become totally and permanently disabled
• You’re a qualified reservist called to active duty

Required Minimum Distributions

Eventually, the IRS will require you to take money out of your 401(k). These required minimum distributions (RMDs) generally begin at age 73. If you’re still working and don’t own more than 5% of the company you work for, you may be able to delay RMDs until after retirement.

New(er) Withdrawal Flexibility Under The SECURE Act

Recent legislation has introduced several penalty-free withdrawal options, reflecting Congress’s attempt to balance long-term savings incentives with real-world financial pressures.

While these withdrawals avoid the penalty, they’re still subject to income tax — and they’re only available if your plan adopts them.

Penalty-free withdrawals are possible when funds are used for:

• Emergency expenses – You may take one penalty-free withdrawal per year, up to $1,000, for unforeseeable emergencies.
• Domestic abuse victims – Up to $10,000 (or 50% of your balance) can be withdrawn and repaid within three years to avoid taxes.
• Birth or adoption – You may withdraw up to $5,000 for related expenses.
• Natural disasters – You may withdraw up to $22,000, with income tax spread over three years and repayment allowed during that period.
• Long-term care premiums (starting in 2026) – You may withdraw up to $2,500 annually for qualified insurance.
• Terminal illness – Withdrawals are allowed, with taxes spread over three years.

The SECURE 2.0 Act of 2022 also authorizes plans to include a new “pension-linked emergency savings account” (PLESA) feature that some 401(k) plans may offer to help employees save for short-term emergencies. It’s a small Roth savings account (up to $2,500) that sits within your 401(k) but can be accessed anytime without early withdrawal penalties. You can ask your employer or HR team if your 401(k) plan includes this option for emergency savings.

What About Roth 401(k) Contributions?

While a Roth 401(k) offers the appealing prospect of tax-free withdrawals in retirement, taking money out too early can still come with consequences. Because Roth 401(k) contributions are made with after-tax dollars, you may always withdraw your own contributions without additional tax. However, the earnings on those contributions are a different story if withdrawn before you reach age 59 ½ or before your Roth account has been open for at least five years. Those earnings are generally subject to both ordinary income tax and a 10% early withdrawal penalty if you’re under age 59 ½. The “five-year rule” often catches people by surprise, and it applies separately to each Roth 401(k) you open. Even though Roth 401(k)s promise tax-free income later, accessing funds too soon can erode that benefit quickly.

The Case For Staying Invested

Just because you can withdraw funds doesn’t mean you should. Even a short break from market participation can reduce your long-term growth potential, as you lose out on compounding and dollar-cost averaging from ongoing contributions.

Before tapping your 401(k), explore other options, such as emergency savings, short-term credit or personal loans. Protecting your retirement savings now can strengthen your financial future when income security matters most.

Bottom Line

A 401(k) is designed to serve your future self, not your current cash flow. Understanding the “why” behind withdrawal restrictions can help you make smarter financial decisions today — and preserve the foundation of your retirement tomorrow.

This commentary is provided for general information purposes only and should not be construed as investment, tax or legal advice, and does not constitute an attorney/ client relationship. The information contained herein has been obtained from sources deemed reliable but is not guaranteed. Past investment performance is no guarantee of future performance.

[1] https://institutional.vanguard.com/content/dam/inst/iig-transformation/insights/pdf/2025/has/2025_How_America_Saves.pdf