You faithfully put in your allotted percentage from each paycheck before taxation, and if you’re lucky, you have a job with a company that matches up to a certain percentage.
Then, if all goes well, you continue to work until retirement age (which is to say, 59½ years old), when you have hopefully saved up enough of a nest egg to support you throughout your twilight years.
Unfortunately, there are times when you must begin withdrawing money from your 401K early (due to job loss, sudden illness, early retirement, or any number of other unexpected misfortunes).
Whatever the reason, withdrawing funds from a retirement account before maturation can come with a number of drawbacks, so before you do anything, you should know what you’re getting into.
Here's what you need to know about 401k early withdrawal penalties.
Avoid Biggest Early Withdrawal Penalty
To start with, the largest early withdrawal penalty you will face (on top of the regular taxes that come with any perceived income) is the 10% additional tax. The IRS actually allows certain exemptions, such as in cases of death (when funds are doled out to beneficiaries), permanent disability, separation from employment at the age of 55 or over, excessive medical bills (over 7.5% of your adjusted gross income), and divorce settlement payments (as mandated by a qualified domestic relations order). However, these are instances in which you take out the money with no intention of returning it to the account at a later date.
If you don’t meet any of these exemptions, however, there are still ways to access your money without paying this extreme penalty (or any other penalties that may be attached).
401k Distribution Alternatives
Some 401K plans offer an alternative that is not a “withdrawal” in the strictest sense of the word. In essence, you may be able to borrow on your account. Many companies do not pay for this extra feature, but if your plan is one of the few that offer this option, there are certain restrictions. Unlike early withdrawal, the restrictions are not on what the money is being used for, but rather on when and how the funds are returned.
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Some employers enact their own guidelines for usage to minimize the number of employees taking advantage of the loan feature (such as limiting disbursements to payments for employee or spousal education, medical bills, down payments on a first home, or payments to avoid foreclosure). But in general, the account itself does not require the borrower to meet any qualifications pertaining to reasons for withdrawal.
However, in order to make it a legitimate legal loan, borrowers must pay back the amount taken out, plus interest. The interest rate may vary by plan, and they are often quite low, but it may be determined to be the prime rate at the time of withdrawal, generally plus one percent.
Additionally, there is a minimum withdrawal amount (usually in the neighborhood of $1,000) as well as a maximum (usually around 50%, but sometimes it is a specific amount of money, such as $50,000). Payments are taken out of payroll checks.
Avoid Early 401k Withdrawals if Possible
In the long run, it behooves you to avoid withdrawing from your retirement account early if at all possible, since you will most likely be very glad to have the funds when you actually retire. And if you do end up paying penalties, you are pretty much just throwing away money that you worked hard to earn. But if you find yourself in a situation in which you have no choice but to withdraw funds from your 401K, you do have a few options to consider.
None of them is precisely ideal, and you will more than likely end up paying at least income tax on any withdrawal, but you may be able to avoid additional penalties if you get all your ducks in a row.
Leon Harris writes for a Canadian financial blog with an emphasis on careers, real estate, politics, and banking.