Understanding 401k Early Withdrawal Penalties

There are extensive 401k early withdrawal penalties in tapping into your retirement money before your golden years. Some savers may be exempt from 401k early withdrawal penalties, while others will pay dearly. How do you know which camp you’ll be in? This can be answered in one simple question: why do you want the money?

10% 401k Early Withdrawal Penalties

Generally speaking, most will pay a flat 10% 401k early withdrawal penalties on the amount taken, as well as income taxes on the amount they withdraw. It is important to note that when you take money out of a 401k, it is treated like ordinary income, since you were able to skip paying the original income taxes on the amount you invested originally. The money you withdraw has not once been taxed, but you can bet it is taxed upon withdrawal!

The 401k early withdrawal penalties apply to anyone who has not yet reached the age of 59 and ½ years old. That age is considered to be “retirement age,” and all withdrawals prior to 59 and ½ years require the payment of a penalty, even if your half-birthday is only two days away.

Exceptions to the Rule

There are few IRS rules that do not have exceptions, but 401k early withdrawal penalties are not one of them. In order to withdraw early and without penalty, you must match one of the following criteria: have died, retired at the age of 55 or otherwise left your previous job at an age older than 55, or have received payouts over the course of your lifetime.

There are two additional, and very common, 401k early withdrawal waivers. These 401k early withdrawal waivers include: medical expenses greater than 7.5% of AGI (adjusted gross income) or if the 401k was dissolved or divided in the case of a divorce. The latter 401k early withdrawal waiver, a divorce, requires a court order, and it cannot be used as an excuse for any withdrawal that happens at the time of a divorce.

When Taking 401k Early Withdrawal Penalties Make Sense

Perhaps the most reasonable excuse for early withdrawals is for a medical expense payment. Because the limits are so high (7.5% of adjusted gross income), the few injuries or illnesses that reach the top of the medical cost pyramid usually cause disability and short or long-term unemployment.

As a result, many who have lost their income look toward alternative sources, including their 401k, to pay everyday expenses. Such action requires careful planning, however, and should be done only when the costs are outweighed by the rewards.

For example: Jim is hurt in an accident and has medical bills of $10,000. He earns $50,000 per year and thus qualifies for this particular exemption from fees. He owns his home worth $120,000, but has an outstanding debt in the amount of $5,000. His state has very little protection in the form of a homeowners exemption for bankruptcy, and thus any bankruptcy will require that he liquidate his home.

To protect his home, Jim pulls $10,000 from his 401k, pays taxes with available cash and makes good on his medical bills. The tax and fee burden, compared to the forced sale of his home in medical bankruptcy, turns out to be a favorable deal. He makes good on his debts, and keeps his home.

Such example scenarios as the one above are very rare. In fact, most who access their retirement early do so for all the wrong reasons, and thus pay dearly in retirement. It is only in high benefit and low cost scenarios that paying 401k early withdrawal penalties make sense.
Tim Ord
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