How to Avoid 401(k) Withdrawal Penalties

401(k) plans are designed to help in retirement, but if you don’t follow the rules, you may find yourself facing 401(k) withdrawal penalties.

This is because the purpose of a 401(k) plan is to provide money following retirement from employment – not function as a general savings account.

If you are unaware of 401(k) withdrawal penalties, you may be shocked when you get stuck with a high tax bill.

Read on to learn more about 401(k) withdrawal penalties and how to avoid them.

 

Rules for 401(k) Withdrawals at Retirement Age

There are rules for withdrawing funds from a 401(k).

If you do not follow these rules, you may face 401(k) withdrawal penalties.

For instance, while you can withdraw money from your 401(k) at any point, you may face a penalty from the IRS of 10% if you withdraw funds before age 59½.

Distribution Rules

When you are ready to withdraw from your 401(k), there are rules about how the funds are distributed. 

You may opt to receive regular distributions for a set period of time, or you may opt to take lump-sum withdrawals. 

The remaining money is still invested, and your portfolio may change based on these investments.

You can also cash out your 401(k). 

However, you will be required to pay taxes on the full amount of the withdrawal, which could mean a huge tax bill and possibly a higher tax bracket. 

Your age plays a leading role in distribution rules. 

If you withdraw from your 401(k) before 59½, this is considered an early withdrawal and is subject to penalties. 

You can keep your money in your 401(k) until you are 73 or 75. 

At this age, you must take required minimum distributions (RMDs) regularly. This is a set amount based on your life expectancy and account balance. You may withdraw more than this set amount, but you are not allowed to withdraw less. 

If you were born from 1951 to 1959, you can begin taking RMDs when you turn 73. If you were born in 1960 or later, you can begin taking RMDs at 75.

If your 401(k) plan holds less than $5,000, you may be required to take a lump-sum distribution.

Tax Rules

When you withdraw money from a traditional 401(k), it is taxed as regular income in the year you take the money out. 

This means you will pay taxes on the withdrawals at your current income tax rate.

Your 401(k) withdrawals will be considered taxable earnings for the year they were withdrawn.

However, the tax benefits of a 401(k) plan are designed to help you save for retirement. 

By deferring taxes until retirement, you may be in a lower tax bracket than you would have been when you initially made the contributions.

Contribution Rules

Once you retire and leave your employer, you are no longer allowed to contribute to your 401(k) plan. 

Should your plan only contain between $1,000 and $5,000, your employer may try to force you out of the plan, and you may be required to roll over funds. 

The other option for those with less than $5,000 is to take a lump-sum payment. 

If you want to continue to contribute to a retirement savings vehicle after you retire from your employer, you may want to consider rolling over your 401(k) savings into an IRA.

However, you are still only allowed to contribute earned income, so this option is for those who have not fully retired and are still earning some sort of taxable income (such as part-time income in post-retirement).

 

401(k) Withdrawal Penalties

The IRS requires an automatic withholding of 20% of a 401(k) early withdrawal for taxes.

For instance, if you withdraw $15,000 from your 401(k), you may only get about $12,000 after taxes are taken out. 

Along with the withholding taxes, the IRS will also hit you with a 10% penalty on all funds withdrawn when you file your tax return – if you’re under the age of 59½.

But it’s not just a 10% penalty. 

The amount withdrawn may also be taxed as ordinary income for the year the money was taken out – which may push you into a higher tax bracket, forcing you to pay even more taxes.

Now, back to the example. 

Let’s say you’re under 59½, and you pull out $15,000 from your 401(k). 

At this point, you are up to 30% in taxes and penalties. 

This means you may only get about $10,500 of the $15,000 early withdrawal. 

The exact number depends on individual tax circumstances – some may get some of the 20% withholdings back

[Related Read: Why a 401(k) Withdrawal Should Be Your Last Resort]

 

How to Avoid 401(k) Withdrawal Penalties

The first way to avoid the penalty is to wait until you are 59½ to take money out of your 401(k).

However, there are some situations that may qualify for an exemption from the 10% penalty.

• The first way is if you qualify for a substantially equal periodic payment plan.
  With this plan, retirement plans may be cashed out penalty-free. But this is only if you take annual distributions for a period of 5 years or until you turn 59½. However, income tax must still be paid on the withdrawals.

• The second way is if you leave your job – but this only applies to those aged 55 and over.
  This is what is called the 55 and Separated from Service rule. This is an IRS policy that allows workers aged 55 and over to take early withdrawals from their employer-sponsored retirement accounts without paying a 10% penalty provided that they leave their jobs. It only applies to accounts you have with your current employer. But you will still owe taxes on the withdrawal, and funds withdrawn will be taxed as ordinary income.
• The third is if you’re getting a divorce and must pull money out of your 401(k) to give to your spouse.
  If this happens, then you won’t be charged a penalty for taking money out of your 401(k).

 

Situations That Qualify for Hardship Withdrawal

Another means for avoiding 401(k) withdrawal penalties is to take a hardship withdrawal.

A hardship withdrawal is a withdrawal of funds from a retirement plan due to “an immediate and heavy financial need,” and if you qualify, you usually don’t have to pay the penalty. 

Situations that qualify for a hardship withdrawal: 

• Medical bills for you, your spouse, and your dependents 
• Money to buy a house
• Money to avoid foreclosure or eviction 
• Higher education expenses for you, your spouse, or your dependents 
• Funeral expenses 
• Disability
• Adoption purposes
• Disaster 
• Military reservist 

Now, in order to qualify, you need to prove you can’t get the money anywhere else – for example, you can’t get a loan, and you don’t have a savings account.

The administrator of the 401(k) will have to approve a 401(k) hardship withdrawal. They’ll want to see the documentation of the hardship. 

Keep in mind – If you do qualify, you will still have to withhold 20%, and it’s taxed as ordinary income.

[Related Read: The Real Impact of 401(k) Hardship Withdrawals]

 

The Longer You Wait, the Better

Ultimately, the longer your money is invested in your 401(k), the more it has the opportunity to grow.

While you cannot continue contributing to your 401(k) after you retire, your money can still grow while it is invested.

Another thing to consider is when to retire.

The longer you wait to retire, the better.

In addition to giving you more time to contribute to your 401(k), Social Security benefits are based on your highest 35 years of earnings.

Speak to a financial advisor and a tax professional before you make any 401(k) withdrawals.

They can help you understand the tax implications, 401(k) withdrawal penalties, and your financial future. 

 

Click below to book a complimentary 15-minute 401(k) Strategy Session with one of our advisors today.

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