What Is The Penalty For Withdrawing From 401k Early?

Saving money for when you stop working is smart, and 401(k) plans are a way to do that. But taking money out early can be tricky and might cost you extra.

Lots of people put money into their 401(k) or other retirement savings accounts every year. It’s like putting coins in a piggy bank for when you’re older. But sometimes, unexpected things happen, and you might need those coins sooner.

Let’s explore what happens if you need to take out your savings early, and exceptions to avoid penalty for withdrawing from 401k early.

What is the penalty for withdrawing from 401k early?

The 401(k) early withdrawal penalty is a significant financial consequence imposed by the IRS when individuals withdraw money from their 401(k) accounts before reaching the age of 59 ½. This penalty is in addition to regular income taxes on the distributed amount, thereby reducing the immediate value of the withdrawal.

When can you withdraw from 401k without penalty?

If you want to avoid the tax implications of withdrawing from 401k before age 59½, there are certain situations that allow you to do this without incurring the 10% early distribution tax penalty. Take a look at these qualified exceptions:

Medical bills without reimbursement

In specific circumstances, you can make penalty free 401k withdrawal to cover unreimbursed deductible medical expenses that exceed 10% of your adjusted gross income. The withdrawal must occur in the same year the medical bills were incurred, providing financial relief for unexpected health costs.

Incapacity or Disability

The IRS will not impose any penalty for withdrawing from 401k early if you’re permanently disabled. Valid proof, such as disability payments from an insurance company or Social Security, is generally required to access these funds without incurring the 10% penalty.

Beneficiaries’ withdrawal after passing

When the account holder of a 401(k) passes away, beneficiaries can access the account without facing the 10% penalty. It’s essential to note that certain limitations may apply to spouses who inherit an IRA, and they might be subject to the penalty if they take a distribution before reaching age 59 ½.

If you owe the IRS

In the event of IRS levies against your 401(k) due to unpaid taxes, you’re allowed to make penalty free 401k withdrawal to address the tax debt. This option can provide relief when dealing with tax-related financial challenges.

For income purposes

Section 72(t) of the tax code allows investors to take money out of their retirement plan for income, but there are restrictions. “You’ll have to take substantially equal periodic payments” over time, Kirchner says. The shortest amount of time that payments must be made is five years. One option is taking a distribution annually for five years or until age 59 1/2, whichever is longer.

Early Retirement from Work

If you leave your job in the year you turn 55 or later (50 if you work in specific federal law enforcement, firefighting, customs, border protection, or air traffic control roles), you may avoid the 10% penalty for withdrawing from 401k established by your employer. This provision recognizes the unique situations of individuals transitioning into retirement or alternative employment.

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Giving birth or Adoption

When you experience the joyous event of giving birth to a child or adopting a child, the IRS allows for a specific exception to the 10% early withdrawal penalty from your 401(k). This exception allows you to withdraw up to $5,000 from your 401(k) to cover qualified expenses related to the birth or adoption of the child.

401(k) Division in Divorce

If your divorce settlement involves cashing out a 401(k) to split with your ex-spouse, the withdrawal for this purpose may be penalty-free, provided it aligns with the court’s qualified domestic relations order.

Disaster Relief

In cases where you are a victim of a disaster for which the IRS grants relief, penalty-free withdrawals may be permitted. This provision acknowledges the unforeseen and challenging circumstances individuals may face due to natural disasters or other catastrophic events.

If you are converting your 401(k) to an IRA

Rolling over the balance from your 401(k) to another eligible retirement plan within 60 days without incurring the 10% early withdrawal penalty. IRAs have slightly different withdrawal rules from 401(k)s, and specific benefits within an IRA could enable you to access funds with fewer penalties.

How to avoid penalties for withdrawing from 401k early?

To safeguard your 401(k) or IRA from early withdrawals, adopt these strategies:

Prioritize an Emergency Fund: Create a safety net by saving at least six months’ worth of living expenses. Keep this fund in a high-yield savings account to earn better interest and be prepared for unexpected events without tapping into your retirement funds.

Exercise Caution with Promotional Credit Cards: If a need arises, leverage credit cards with zero percent introductory offers, but stay vigilant. Clear the balance within the promotional period to avoid higher interest rates afterward.

Seek Support from Friends and Family: When facing financial difficulties, consider reaching out to your social circle. They often provide more flexibility and understanding than traditional lenders, enabling you to weather tough times without resorting to your retirement savings.

Consider Personal Loans Carefully: Evaluate the potential of personal loans, which don’t require collateral like your home or car. Applying at a bank or credit union where you have an established relationship could increase approval chances and may provide flexibility if you encounter payment challenges.

Explore Portfolio Line of Credit: This option, backed by securities from your investment portfolio (e.g., stocks, bonds), offers lower interest rates due to collateral. However, be mindful that the value of your collateral can impact loan terms. Government bonds are usually considered safer than riskier assets.

Conclusion

While there are ways to avoid penalty for withdrawing from 401k early, it’s a good idea to keep your retirement savings untouched until you retire.

Here’s the thing: when you take money out early, the power of “compounding” – which helps your savings grow – doesn’t work as well. So, you might miss out on extra money in the long run.

If you want to take charge of your money situation, start by taking a step back, getting organized, and looking at your money as a whole picture. This way, you can make sure your financial journey stays on the right track.

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FAQ

What age can I get money from my 401k without penalty?

The general rule is that you can start withdrawing money from your 401(k) without facing the 10% early withdrawal penalty once you reach the age of 59 ½. At this age, the IRS considers you eligible for penalty-free distributions. However, regular income taxes will still apply to the withdrawn amount, as it’s treated as ordinary income.

Is the 10% penalty waived if I take a 401(k) loan instead of a distribution?

No, the 10% penalty is not waived if you take a loan from your 401(k). When you take a loan from your 401(k), it’s considered a loan that you’re expected to repay, not a distribution. Therefore, you don’t pay taxes on the loaned amount, but you’re obligated to repay it, typically within a specified period. If you fail to repay the loan for any reason, you’ll owe both taxes and a 10% penalty if you’re under 59½.

How does the “Rule of 55” work?

The “Rule of 55” is a special provision that allows individuals who leave their job in the year they turn 55 or later (50 for certain professions) to withdraw funds from their current employer’s 401(k) without the 10% early withdrawal penalty. This rule is specific to the 401(k) of your current employer, and it applies to funds in that particular plan. It’s essential to note that the Rule of 55 doesn’t apply to IRAs or 401(k)s from previous employers.

Are there specific forms or paperwork I need to complete to request a penalty free 401k withdrawal for qualified reasons?

Yes, in most cases, there are specific forms or paperwork you need to complete to request a penalty-free withdrawal for qualified reasons. Each situation may have its own requirements, and your 401(k) plan administrator or financial institution will typically provide the necessary forms. It’s crucial to work closely with your plan administrator to ensure you follow the correct procedures and provide any required documentation to demonstrate that your withdrawal qualifies for an exception to the 10% penalty. Consulting with a qualified financial advisor can also help you navigate the paperwork and ensure you meet all the necessary criteria.

Sources: bankrate.com