401k Withdrawals: What Penalties You Should Expect

401(k) plans are a powerful retirement savings plan that many employers offer in the United States. Its tax advantages and employer contribution match policy make it a favorite retirement account for many Americans. 401(k) plans also come with their limitations to make sure that account holders are incentivized to withdraw their money from the account once they reach a certain age. To do that, the account is designed to make it very expensive for ineligible people to withdraw money from it through an early withdrawal penalty of 10% of the withdrawal amount.

Generally, withdrawing the money from a 401(k) plan is a bad idea unless you are eligible to withdraw the money penalty-free. Even if you are hit with a financial burden, you may want to tap into a 401(k) plan as the last resort because there are cheaper alternatives to 401(k) withdrawal. Regardless of the financial situation you may have, it is better to avoid withdrawals from 401(k) unless you are exempt from the early withdrawal penalty. The IRS outlines exceptions to the early distribution penalty as well as eligible deductions.

Early Withdrawal Penalty Exemptions

A 401(k) plan is designed in a way that the account holder has to pay a 10% early withdrawal penalty by default, but there are a few factors that make the account holder exempt from the penalty. If any of the following factors apply to the 401(k) account holder, then you may be able to avoid paying a 10% early withdrawal penalty.

  • Age – 59.5 Years or Older

One of the most straightforward ways to avoid an early withdrawal penalty is to simply wait. Once the 401(k) account holder reaches the age of 59 years and a half, they are eligible to withdraw the money from the account without any penalties. It is important to note that the funds may still be taxed on federal and state levels as ordinary income.

  • Death – Account Holder Deceased

If an account holder is deceased, then the funds in the account can be passed down without any penalty. Depending on the way it is passed down, some taxes, including inheritance tax, may apply.

  • Disability – Account Holder Has a Total and Permanent Disability

If an account holder has a total and permanent disability, they are eligible to withdraw the money from 401(k) without the early withdrawal penalty.

  • Separation from Service – Account Holder Has Retired at an Eligible Age

An account holder who has separated from service, or retired, can be eligible for an early withdrawal exemption if they separated from service at age of 55 or older. Qualified public safety employees can be eligible for an early withdrawal exemption if they have separated from service at age of 50 or older. If you retired before hitting the age of 55, you may not be eligible for an early withdrawal penalty exemption. In that case, you will have to wait until you are 59.5 years old to withdraw the money without the penalty.

Early Withdrawal Deductions

The IRS also permits you to withdraw some funds from your account without paying the 10% early withdrawal penalty on it. Eligible expenses have a limit to them, and some of them need to be directly discussed with the account provider. The following list provides an overview of the expenses that can be exempt from the 10% early withdrawal penalty.

  • Automatic Enrollment

Some 401(k) plans allow withdrawals from the plan with auto-enrollment features. These withdrawals are exempt from the 10% early withdrawal penalty.

  • Corrective Distributions

In cases when there are excess contributions, excess aggregate contributions, and excess deferrals on the account, corrective distributions are applied and are exempt from early withdrawal penalty.

  • Domestic Relations

In some cases, the court may rule that payments are due in domestic relations such as a divorce or child benefits. Withdrawals that go to an alternate payee under a Qualified Domestic Relations Order are not subject to the 10% early withdrawal penalty fee.

  • Equal Payments

If the funds are withdrawn through specified annual distributions until the account-holder turns 59½, the funds are not subject to the early withdrawal penalty. It is important to note that equal payments must be made for at least 5 years to be exempt from the penalty, which means that if you are close to turning 59 years and a half, it might be better to wait than to exercise equal payments withdrawal.

  • Employee Stock Ownership Plan (ESOP)

If you have any dividends in your account that are passed through an Employee Stock Ownership Plan (ESOP). An ESOP must be designed to mostly invest in qualifying employer securities and meet certain requirements to be eligible for the exemption.

  • Levy

Retirement plans are often taxable and require some funds to be withheld at the time of transaction. A 401(k) withholds 20% of the withdrawal for the income tax, but some of that may be returned later to the account holder if their tax liability is less than what was withheld. These proceedings are distributed free of the early withdrawal penalty.

  • Medical

401(k) plan allows for some medical withdrawals that are exempt from the early withdrawal penalty fee. The plan allows the account holder to withdraw the amount of unreimbursed medical expenses of no more than 10% of Adjusted Gross Income in 2021.