Is Your 401(k) or IRA the Better Option?

When an unexpected financial crisis hits, an emergency fund is the ideal safety net to cover surprise expenses. However, an alternative—and sometimes the only option—for relief is your retirement savings.

Dipping into your 401(k) or IRA early has real financial consequences, including taxes, penalties, and lost future growth.

But if you’re in a bind and have to make a choice, which account should you tap?

Withdrawing from Your 401(k) or IRA

You should consider the penalties attached to withdrawing money from your 401(k) or individual retirement account (IRA) to cover a financial emergency.

Early withdrawals from 401(k)s and traditional IRAs work similarly: if you take money out before age 59 1/2, a 10% early withdrawal penalty is triggered in addition to income tax.

However, Roth IRAs are more flexible. You can always withdraw your contributions (but not the earnings) tax- and penalty-free, regardless of your age.

Although the penalty is the same for both 401(k)s and traditional IRAs, how easily accessible the funds are also influences which account to use in a financial emergency.

“With an IRA, individuals have more direct access—no need for employer permission, and custodians typically have fewer restrictions,” said Skyler Denny, certified financial planner and founder of Legacy Financial Designs.

“401(k) withdrawals, on the other hand, are subject to plan-specific rules and may not allow in-service distributions or hardship withdrawals at all, even though the IRS allows it. The employer still has the ability to make these options available or not,” Denny told Investopedia.

That said, the IRS allows penalty-free withdrawals from both accounts in certain cases:

Exceptions for 401(k)s:

• Permanent disability
• Separation from service at 55 or older
• Medical expenses exceeding 7.5% of adjusted gross income (AGI)
• Qualified domestic relations order (QDRO)
• Substantially equal periodic payments (SEPP)
  

Exceptions for IRAs:

• Permanent disability
• Medical expenses exceeding 7.5% of AGI
• Substantially equal periodic payments (SEPP)
• First-time home purchase, up to $10,000
• Qualified higher education expenses
• Health insurance premiums while unemployed

An additional exception, under the SECURE 2.0 Act, allows you to take withdrawals from a retirement account for emergency expenses without the 10% early withdrawal penalty.

“Starting in 2024, individuals can take one penalty-free withdrawal of up to $1,000 per year from a 401(k) or IRA for ‘unforeseeable or immediate financial needs.’ Taxes still apply, but there’s no 10% early withdrawal penalty. If the money is repaid within three years, no taxes are owed. If not, you can’t take another emergency withdrawal until it’s repaid or the three years have passed,” Denny explained.

Choosing the Right Account in a Financial Crisis

It might make the most sense to withdraw from your 401(k), specifically by taking out a 401(k) loan.

“Ultimately, the best option depends on your age, account types, and plan rules, but if a 401(k) loan is available and affordable, it often provides more flexibility with less long-term damage than a permanent withdrawal from an IRA,” Denny said.

You can borrow up to 50%, or up to $50,000, of your vested balance as long as the loan is repaid on time, typically within five years.

The loan accrues interest, but the payments go back into your account.

However, if you leave your job before repaying the loan, the outstanding amount may be treated as a taxable distribution and could incur a 10% penalty if you’re under 59 1/2.

While IRA loans don’t exist, there’s a 60-day indirect rollover option that functions as a workaround, somewhat like a loan.

“This allows you to withdraw funds and redeposit them into the same (or another) IRA within 60 days to avoid taxes and penalties. However, this strategy carries risk—if the funds aren’t replaced in time, the distribution becomes fully taxable, may trigger a 10% early withdrawal penalty, and this option can only be used once every 12 months per taxpayer,” Denny said.

Recovering From Early Withdrawals

Many people focus on the immediate financial relief, but they often overlook the long-term implications of withdrawing funds from any retirement account in an emergency.

“Ultimately, the biggest cost is something called opportunity cost. Where withdrawing from retirement accounts permanently removes those funds from compounding growth—and for younger investors, that could mean hundreds of thousands in lost future wealth,” Denny explained.

While it’s best to avoid tapping into your retirement savings whenever possible, life doesn’t always go according to plan. With a solid strategy in place, though, recovery is possible.

This is how Denny recommends recovering:

• Look at the withdrawal as temporary: If your withdrawal is allowed to be repaid, focus on paying it all back as soon as you can, and definitely within the time allowed (usually three years). You’ll avoid owing taxes and can get your money working for you again.
• Increase contributions: Even though you’re missing out on the compounding interest related to your withdrawal, try to increase your contribution amounts if possible.
• Establish an emergency fund: Start building an emergency fund with three to six months’ worth of expenses. A high-yield savings account is a good option.

The Bottom Line

It’s never a good idea to dip into your retirement savings, even in an emergency. But if it’s necessary, understanding the differences between 401(k) and IRA withdrawal rules and exceptions can help minimize the penalties and taxes you may face.

“Tapping into your retirement plan shouldn’t be taken lightly, but it also doesn’t have to define your financial future. The key is to respond with a plan—not just regret—and use it as a catalyst to create better systems going forward,” underscored Denny.