Early withdrawal penalty tax
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401(k) withdrawal rules
Early 401(k) withdrawals can reduce the ultimate value of your retirement savings, and required minimum distributions determine just how long you can defer taxes. To reap the maximum benefits of your 401(k) plan, it’s important to understand the requirements and exceptions that govern distributions.
What is the 401(k) withdrawal age?
401(k)s are often the largest portion of a family’s retirement savings. For that reason, it’s important to understand the rules that determine when and how to use them. 401(k) distributions are governed by two age-based conditions. On the one hand, they determine how soon you can start taking money out of the account. On the other, they determine how long you can enjoy tax-advantaged growth before being required to take distributions. Here is an overview of both:
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If you withdraw funds from a 401(k) before age 59½, you could be subject to a 10% penalty tax and lose some tax advantages. There are exceptions (see below). |
Between ages 73 and 75, depending on your birth year, you must start taking distributions from your 401(k). |
The early withdrawal penalty tax is an incentive to hold on to savings until retirement. Required minimum distributions (RMDs) ensure that people don’t take advantage of the system by deferring taxes indefinitely.
Related: What is a 401(k)?
401(k) withdrawal penalty tax
While you can take 401(k) distributions at almost any age, doing so before 59½ could mean leaving thousands of dollars on the table. Early 401(k) withdrawals trigger a 10% penalty tax. Depending on the type of plan you have, taxes may also be due, further decreasing the benefits these accounts are designed to provide.
401(k)s are meant to support future financial stability. That’s why withdrawal conditions were created to encourage leaving the money untouched until retirement, a time when having additional income from multiple retirement products may be vital.
Why do people withdraw from their 401(k)s early?
People tap into their 401(k) accounts for many reasons. They may be unable to secure a loan or financing at a time when cash is critical, a business opportunity may present itself, or a sudden hardship may disrupt their ability to take care of their family. Although early withdrawal comes with a penalty tax, several exceptions can provide relief if you need funds sooner rather than later.
How can you avoid the 401(k) withdrawal penalty tax?
Early-withdrawal provisions can provide much-needed help in tough times. However, 401(k) plans are not required to offer them. Exceptions are often narrowly constructed, and you may still owe federal and state income taxes on the distributions. It’s important to check the specific details of your plan when considering a withdrawal. A few examples of penalty tax exceptions include:
Hardship distributions
The IRS generally defines hardship as an immediate and heavy financial need. Qualifying circumstances may include disaster recovery for a federally declared disaster, if you’re a victim of domestic abuse, or you have a terminal illness or disability diagnosis. Each 401(k) plan is left to provide its own specific definition of hardship, and the amount that can be withdrawn is restricted.
The rule of 55
Withdrawals that avoid the penalty tax can be made against an employer-sponsored 401(k) plan at age 55 or older. This exception only applies if the employee leaves their job at 55 or older and takes distribution in that same year. The separation from employment can be for any reason (e.g., quits, is fired, or is laid off). Only funds from the most recent employer’s plan are eligible for this exemption. Funds from previous employer plans are subject to the 10% penalty tax.
Loans
You may be able to borrow against your 401(k) if your plan allows it. This type of loan will not incur taxes if it meets certain requirements and you follow the repayment schedule. If you don’t follow the repayment schedule, you may incur the 10% IRS penalty tax and income taxes will also apply.
Life events
Some life events that qualify for a penalty tax exemption include the birth or adoption of a child, the purchase of a first home, or being called to active duty from the military reserve. An IRS levy or court-mandated payments, such as the division of assets in a divorce decree, may also qualify.
The above circumstances represent only a few of the possible exemptions. For more information, visit IRS.gov.
What if your early withdrawal does not meet an exception?
Early distributions are reported to the IRS. If you aren’t eligible for a penalty tax exemption, they will apply. Federal and state income taxes are owed on the amounts withdrawn from traditional 401(k)s, since they are funded with pretax dollars. With Roth 401(k)s, income taxes are not owed on the withdrawal of your contributions, but income taxes and the 10% penalty tax may apply on the withdrawal of earnings, unless an exception applies. It’s important to keep taxes and penalties in mind when making an early withdrawal. That way you can take out enough money to meet your needs and these requirements.
401(k) rules are a strong incentive to let your money grow untouched until retirement. However, understanding these rules can help you avoid penalties if you need early access to your account. When seeking the best options for your future finances, consulting a professional financial advisor may prove helpful.
401(k) required minimum distributions
RMDs are minimum amounts that must be withdrawn from your 401(k) annually. Distributions must begin anywhere from 73 or 75 years of age, depending on your birth date. RMDs are subject to income taxes and designed to prevent indefinite tax deferrals at the government’s expense. While these distributions apply to traditional 401(k)s, as of 2024 Roth 401(k)s are no longer subject to RMDs during the participant’s life.
401(k) withdrawal FAQs
Withdrawals that avoid penalty taxes can be made from a 401(k) beginning at age 59½, and certain exceptions allow withdrawals even earlier.
A hardship loan is a loan you can take against your 401(k) if faced with an immediate and heavy financial burden. These loans are exempt from income taxes and the 10% early-withdrawal penalty tax. However, 401(k) plans are not required to offer them.
Withdrawals from a traditional 401(k) are considered taxable income, and you are responsible for paying taxes on them based on your current tax rate. If you have a Roth 401(k), withdrawals will generally not be subject to taxes since it was funded with after-tax dollars.
Early 401(k) withdrawals are subject to a 10% penalty tax, unless an exception applies. This penalty tax was created to encourage long-term investment to provide a source of funds during retirement.
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This article is provided for informational purposes only. Neither New York Life Insurance Company, nor its agents, provides tax, legal, or accounting advice. Please consult your own tax, legal, or accounting professional before making any decisions.