What You Need to Know About 401(K) Early Distributions and Taxes

401K, IRA, Stocks

If you’ve been a diligent retirement saver, you may have amassed an impressive nest egg in your 401(K).

There are some cases where making an early withdrawal from your 401(K) makes sense and many cases where it could hamper the growth of your retirement savings.

There are two ways to access the money in your 401(K) – a distribution and a loan. A distribution is when the funds are withdrawn from the account with no expectation or ability for replenishment. A loan is when the funds are withdrawn from the account but you are expected to repay the amount plus interest.

Today we’ll explain everything you need to know about early distributions.

You can withdraw your funds from a 401(K) whenever you want for whatever reason – it’s not a lock box.

The government frowns upon people using a tax deferred retirement vehicle as a regular sources of funds, so the IRS has created rules to make the withdrawal very expensive unless you fit certain criteria.

Unless you fit those criteria, you will be subject to an early withdrawal penalty. If you make a withdrawal from your 401(K), it will be subject to a 10% early withdrawal penalty on top of the income taxes due on the amount withdrawn. Your plan administrator will withhold 20% of your withdrawal for taxes plus the 10% withdrawal penalty – leaving you with a much smaller amount than you probably expected.

For example, if you’re in the 28% tax bracket and you try to withdraw $10,000, you’ll lose 38% of your withdrawal to the tax and penalty. $10,000 quickly becomes $6,200 but it doesn’t stop there. You will owe state and local income tax on that amount too — so you will have less than $6,200 in your pocket.

There are ways to avoid this early withdrawal penalty but not the income tax. Here are the common ways you can avoid the 10% penalty:

  • Be over the age of 59.5 – If you withdraw funds and are aged 59.5 and older, it’s not considered “early” and you will not be subject to the penalty.
  • Be over the age of 55 and left employment – If you separate from service during or after the age of 55, you can take early distributions from a qualified plan without penalty.
  • Be permanently disabled – If you are totally and permanently disabled, which is defined by the IRS as an identifiable physical or mental impairment that makes you unable to work, then you are permitted to take early distributions without penalty.
  • Hardship distribution – Your retirement plan is not required to offer this but many do. If they do, the plan will list the reasons they permit a hardship distribution and it often covers cases like medical and funeral expenses. Your company is responsible for providing this list and you’ll have to meet its requirements, which by law only need apply criteria that use nondiscriminatory and objective standard.

Don’t confuse an early withdrawal with a rollover, where you take your 401(K) and roll it over to an IRA after you leave a job. With a rollover, you have 60 days from when you receive the funds from your 401(K) to move it to your IRA. If you exceed that time period, it’s considered a withdrawal and you will be penalized. It’s a common but completely avoidable mistake so keep your eye on the calendar.

It’s important to recognize that withdrawals will remove funds from your 401(K) forever. You will not be able to replenish them and recover the tax advantages of tax deferred investing.

Don’t take the decision to withdraw funds from your 401(K) too lightly!

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