IRS rules regarding 401k plans are founded on the premise that 401k plans are, first and foremost, retirement funding vehicles. Withdrawing money out of a 401k plan for purposes other than retirement or at a time prior to normal retirement age is strongly discouraged by the IRS through application of severe 401k withdrawal penalties.
10% Penalty for Early 401k Distributions – The main 401k withdrawal penalty is the 10% additional tax that is incurred for taking an “early distribution”. An early distribution occurs when 401k funds are withdrawn before reaching age 59-1/2. The 10% penalty is in addition to the regular income taxes that must be paid on amounts withdrawn. (Remember: you did not pay income tax when you contributed funds to the 401k plan so the IRS gets its share when you take money out.)
There are a few limited ways that you can avoid the “under age 59-1/2, 10% penalty”, but they are not especially helpful for most people looking to withdraw 401k money. The penalty-free withdrawals allowed by the IRS are as follows:
- Withdrawals made after you separate employment and you are 55 or over (separation can be in the calendar year you turn 55);
- Withdrawals made to your beneficiary or estate after you die;
- Withdrawals made because you have been permanently disabled;
- Withdrawals made as part of a series of “substantially equal” payments” over the expected lifetimes of the account owner and beneficiary. Generally, you must separate from you employer before payments can begin under this exception;
- Withdrawals made because you have incurred medical expenses esceeding 7.5% of your adjusted gross income. The penalty-free withdrawal can be for an amount up to the amount that your medical expenses exceed the 7.5% threshold; or
- Withdrawals required by a “qualified domestic relations order” (QDRO) as part of a divorce settlement
Additionally, the IRS provides for 401k withdrawal rules for severe financial hardships such as home foreclosure. Generally, even 401k hardship withdrawals will be subject to the 10% penalty.