401k Planning

What are the 401k Withdrawal Penalties?

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 An early distribution occurs when 401k funds are withdrawn before reaching age 59-1/2. The 10% penalty is in addition to the regular income taxes that must be paid on amounts withdrawn.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:

  1. Withdrawals made after you separate employment and you are 55 or over (separation can be in the calendar year you turn 55);
  2. Withdrawals made to your beneficiary or estate after you die;
  3. Withdrawals made because you have been permanently disabled;
  4. 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;
  5. 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
  6. 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.

401k Planning