Because of the tax consequences of making an early 401k withdrawal, it is usually a bad idea to do this. However, there are times when you really have no choice but to dip into your retirement fund. In this case, it is important to make sure you know the 401k withdrawal rules so that you will be well-informed about the cost of taking money out of your 401k before you reach retirement age.
401k Withdrawal Penalty
If you withdraw money from your 401k plan before you reach the age of 59 1/2, you’ll be charged a 401k early withdrawal penalty. This additional tax penalty is equal to 10% of the amount you withdraw. You will also have to pay income taxes on the money you withdraw since it was not taxed before you put it into your 401k. This can increase your income to the point where you fall into a different tax bracket. If this happens, you’ll find yourself owing more income tax than you expected. To avoid extra taxes, it is best to avoid a 401k early withdrawal if you possibly can.
There are several exceptions to the 10% tax penalty. Some of the exceptions are distributions made to your beneficiary after you die, distributions made because of a disability, payments made after you stop working for the company if you are at least 55 years old, and distributions made for the purpose of receiving medical care. You also don’t incur the tax penalty if you receive a distribution of excess contributions or if the distribution is due to an IRS levy against your 401k plan.
401k Hardship Withdrawal
If you are experiencing financial hardship, you may be able to make a 401k hardship withdrawal. This option is available only if you can show an immediate and pressing financial need and do not have any other assets that can be used to satisfy that need. Not all 401k plans allow hardship withdrawals, but if they are permitted, the amount is limited to the amount of need and the distributable amount in the plan. You cannot make elective contributions to the plan for six months after receiving a hardship withdrawal. It’s also important to note that hardship distributions are not treated as eligible rollover distributions.
If you have a 401k plan, you must start taking distributions by April 1 following the year that you turn 70 1/2 years old or April 1 following the year that you retire, whichever is later. Some plans require you to take distributions by April 1 following the year you turn 70 1/2 even if you don’t retire.
Sometimes taking a 401k distribution is necessary, in which case you should be sure to figure out the amount of tax liability that you will need to pay. The plan will withhold 20% of the withdrawal amount, but you might find that you need to set aside an additional amount to cover the taxes on the 401k withdrawal.