What You Should Know About 401k Penalties
The IRS rules regarding 401(k) plans are based on the fundamental notion that 401k plans are primarily designed for retirement funding. The way that the IRS discourages people to withdraw money from their 401k plan for reasons other than to fund their retirement is to apply significant penalties for early withdrawal.
Our guide looks at 401k penalties and what you should know.
The Main 401k Penalties
An ‘early distribution’ occurs when you withdraw funds from your 401k plan before you reach the age of 59 ½.
The main penalty that you will face if you withdraw money from your 401k plan before retirement is the 10% additional tax liability. This 10% penalty is in addition to the regular income taxes that you have to pay on the amounts that you withdraw.
Remember that as you did not pay any income tax when you contributed money to your 401k plan the IRS will take their cut when you take the money out.
Penalty free 401k withdrawals
There are some ways that you can avoid paying the 10% early withdrawal penalty. These include:
- Withdrawals that you make because you have been permanently disabled
- Withdrawals that you make after you separate employment if you are aged over 55
- Withdrawals that are made because of a ‘qualified domestic relations order’ as part of a divorce settlement
- Withdrawals made because you have to pay medical expenses that exceed 7.5 per cent of your adjusted gross income
- Withdrawals made to your estate or beneficiaries after you die
- Withdrawals made as you are separated from service and receive payments in substantially equal amounts over your life expectancy
In addition, there are separate 401k withdrawal for other severe financial hardships such as if you are facing home foreclosure. However, even these 401k withdrawals are likely to be subject to the 10% withdrawal penalty.
You should, of course, remember that withdrawing money from your 401k plan will also reduce the amount of money that you will be able to benefit from in your retirement. You may leave yourself with less money than you need to live comfortably.
If I leave my employer and they want to close down my 401k plan, will I have to pay the penalties?
Kevin – thanks for your question.
Not necessarily. To avoid the taxes and penalties, you could roll the funds from the 401(k) into an IRA, or your new employer’s 401(k). Your new employer’s plan administrator will be able to assist you if you want to go this route. If you would prefer to set up an IRA account (or if you’re not starting a new job) your financial institution will be more than happy to set up an IRA for you.