What is a 401k Withdrawal Penalty?

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What is a 401k Withdrawal Penalty

Interestingly, U.S. households held over $17 trillion in employer-sponsored D.C savings plans and Individual Revenue Accounts in 2018. In 401k defined contribution plans, employees defer a portion of their salaries on a pre-tax basis. This is with the main objective of accumulating assets for retirement life. Known as 401k matching, additional assets are accumulated if an employer makes contributions to a participant’s account. Consequently, 401k withdrawals before age 59½ incur an early 401k withdrawal penalty. This penalty is normally equal to 10% of the withdrawal, plus any income taxes owed.

Why a 401k withdrawal Penalty

While it may seem unfair, a 401k withdrawal penalty serves a purpose. A 401k withdrawal penalty may address moral hazard problems. Firstly, by discouraging mid-life spending hence reducing the social burden of supporting retirees. Secondly, a 401k withdrawal penalty may help stakeholders with self-control problems and avoid prematurely spending with savings. In retrospect, illiquidity of 401k and IRA accounts yields higher after-tax returns than more liquid accounts. Furthermore, about 45% of workers with 401k accounts who leave their jobs, receive their 401k balances as a lump-sum withdrawal. 

Premature 401k withdrawal Penalty

Generally, for participants under age 59½, distributions are subject to a 10% premature 401k withdrawal penalty. This is unless one of the following exceptions apply:

  • Permanently disability
  • If a participant separated from service during or after the calendar year in which he/she attained age 55 years.
  • For payments made to the government to satisfy an IRS tax levy;
  • Death benefits for beneficiaries
  • For Qualified reservist distributions.
  • QDRO distributions to an alternate payee
  • Corrective distributions due to failed nondiscrimination tests or exceeding legal limits
  • For medical expense distributions that don’t exceed deductible medical payments

Mandatory Federal Tax Withholding

Subsequently, if a participant choices to receive a cash distribution, eligible to be rolled over, this taxable portion is subject to 20% mandatory income tax withholding not forgetting that state tax withholding may apply. For instance, if the participant’s taxable cash distribution is $10,000, he will only receive $8,000. Consequently, the other $2,000 will be for the IRS. Sometimes this may not even necessarily be sufficient to cover the tax on the distribution or withdrawal. Additionally, 401k participants can choose to waive tax withholding for distributions ineligible for rollover.

Hardship Withdrawals

A central part of the 401k withdrawal penalty structure is the hardship withdrawal. A recent report reported an 10% increase in hardship withdrawals from 401k accounts in 2018. While financial experts strongly discourage 401k hardship savings, hard times are sometimes inevitable. Furthermore, many defined contribution plans permit hardship withdrawals of salary deferrals. Hardship withdrawals also incur penalties.

After-tax Savings Withdrawal

As we discuss the 401k withdrawal penalty, it’s notable that also after-tax savings withdrawals do exist. These are available to participants who made contributions on an after-tax basis. Furthermore, only money invested as after-tax savings contribution and the earnings on the contributions are available for withdrawal. In retrospect, when you withdraw the 401k funds, you’re also withdrawing your service credit. Sadly, for vested members, this means forfeiting a monthly benefit at retirement age. Additionally, the Internal Revenue Service requires a 30-day waiting period before funds are distributed. This is with the purpose of ensuring you have time to review your options.

Taxes on withdrawals

 Uncle Sam just had to feature in the 401k withdrawal penalty story. I know right! Furthermore, any tax-deferred contributions and interest paid directly to participants automatically has a 20% income tax withheld. Additionally, IRS requires for any after-tax funds to be tracked separately within an account.  For the purpose of avoiding repeated taxation when you withdraw from your IRA or retirement plan. Furthermore, there are taxes withheld on qualified rollovers.

Loans

These don’t incur a direct 401k withdrawal penalty as per se but have penalties. Participants are eligible for 401k loans on a vested account balance. If actively employed or on a leave of absence. Furthermore, such loans must be re-payed within 12-60 months while on the contrary, if a loan is taken for payment for a primary residence,it must be re-payed within 61-120 months.  Additionally, if you leave the organization, you must repay the loan lest the unpaid balance will be considered a taxable distribution and 401K penalties could apply.

Annual limits

The U.S. government adjusts the limits for qualified plans each year to reflect cost of living adjustments. Furthermore, limits are based on the plan year with elective deferral and catch-up limits always based on the calendar year. The IRS form includes information on types of distribution and taxable amount. Furthermore, taxes withheld and whether or not the ten percent 401k withdrawal penalty is applicable.

Conclusion

In conclusion, when dealing with a 401k withdrawal penalty it’s wise to think twice. Simply because taxes and penalties take a sizeable bite out of your withdrawal. Talk to a tax advisor before making any withdrawals since distribution decisions have life changing consequences. Furthermore, you may be in for rude awakening when you complete your tax returns. But when you withdraw from your 401k account before age 59½, you’ll receive a ten percent early 401k withdrawal penalty. Not forgetting the additional tax that may apply and jeopardize your financial security in retirement.

Executive Assistant and Content designer at T3 Direct LLC I have tailored my skills in all verticals of marketing & business development. I have mastered a niche in Lead Generation, Digital Marketing, organize/develop projects, team development, data analysis, & excellent customer service.

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