Tax Penalties When Drawing a 401(k) Early

A 401(k) is a long-term savings and retirement plan typically offered to employees by larger employers. The Internal Revenue Service, as of 2010, grants special tax advantages to 401(k) plans but also regulates their use. For example, there is a limit on the amount you can contribute to a plan, and there are restrictions on when you can access the money in your account.

Allowable Distributions

Generally speaking, there are only limited situations in which the IRS permits you to take a distribution from your 401(k) plan. You may not be able to access your funds unless you become disabled, separate from service with your employer, turn 59.5, incur a financial hardship or die. You can also access your funds if the plan terminates without a successor plan in place.

Regular Taxation

When you contribute to a 401(k) plan, your employer takes the contribution out of your paycheck before you pay taxes on it. Since your contributions and earnings are not taxed while in your retirement account, you must pay ordinary income tax when you take any distributions. Even if your distribution qualifies as a hardship distribution, you still must pay income tax on it. The only exception to the taxation of 401(k) distributions is when you rollover the withdrawal to another tax-advantaged account, such as an Individual Retirement Account (IRA).

Early Withdrawal Penalties

Your retirement plan is intended to be a long-term investment account so you can prepare for the years when you will not be employed. In order to encourage you to invest for the long term, the IRS imposes a penalty if you take money out of your 401(k) well before retirement age. Specifically, you will owe a 10 percent penalty on any amount you take out of your 401(k) before you reach the 59.5. This penalty applies even in the case of a hardship withdrawal, and is in addition to any income tax you owe.

Loans

Although the IRS allows 401(k) loans, employers are not required to offer them to employees. If there is a loan provision in your plan, you can typically borrow half the value of your account, up to a maximum of $50,000. Your employer will take a deduction from your paycheck every month to help repay the loan. However, if you are fired, leave your job or otherwise separate from service with your employer, the entire amount of the loan is due in short order, typically 60 to 90 days. If you do not pay back your loan in the provided time period, the balance of the loan is considered a distribution, subject to ordinary income tax and the early withdrawal penalty, if applicable.

References

About the Author

John Csiszar earned a Certified Financial Planner designation and served for 18 years as an investment counselor before becoming a writing and editing contractor for various private clients. In addition to writing thousands of articles for various online publications, he has published five educational books for young adults.