Withdrawing 401k

When can 401k be withdrawn

401k is an employer-sponsored tax-advantaged retirement account. Workers make direct contributions from their paychecks (before IRS tax withholding) with Employers commonly making a matching contribution. Since the 401k plan confers tax advantages and is meant for retirement, IRS has placed restrictions on 401k withdrawals. Penalty-free funds can be withdrawn at age 59 ½ (early withdrawal attracts a 10% penalty).

Withdrawing 401K savings fully depend on the sponsoring company’s rules and is usually in the form of an annuity or a lump-sum withdrawal.

Age for 401k withdrawal

401k withdrawal at 59 ½

Qualified Distributions Are Allowed at Age 59 ½ (Note that Penalty-free does not mean tax-free)

Before age 59½, account holders face an IRS penalty of 10% for funds withdrawn from a 401k account. At this age, investors are also permitted to convert their company-sponsored 401k into a more flexible individual retirement account (IRA).

401k withdrawal at 72 ½

Withdrawing 401k is voluntary. There is no requirement for an investor to access their 401k savings the minute they retire.

However, IRS rules make it mandatory(unless you’re still working, under some plans) to take withdrawals known as required minimum distributions (RMDs) when the clock turns turn 73 (or age 70, 72, 73, or 75, depending on the year you were born ).

The first mandatory 401k withdrawals are set on April 1 of the year after the investor turns 72, and thereafter they must take a required minimum distribution (RMD) every year. The distributions are based on an investor’s age, life expectancy, and the amount of money in his retirement account.

Failure to make withdrawals that meet the RMD standards may be subject to a 50% excise tax.

This rule prevents savers from perpetually leaving their funds in tax-advantaged accounts and avoids paying taxes (Once you start taking RMDs, your withdrawals will be taxed as ordinary income).

401k withdrawal at age 55

This is available to employees who leave service at age 55 or older (age 50 for most public safety employees) but only from the plan at the job you are leaving.

Early 401k withdrawal rules

Withdrawing 401k for hardship

Early withdrawals are only possible if the plan rules allow it and to address “an immediate and heavy financial need”.

It’s the plan sponsor who chooses which IRS-approved categories are allowed to qualify for a hardship distribution.

This can either be as;

• Hardship situations qualify that qualify for penalty exceptions
• Hardship situations that do not qualify for penalty exceptions

The only other way to access 401k funds is to leave your current employer.

Early 401k withdrawal penalty exceptions

1. Unreimbursed medical bills

IRS allows penalty-free withdrawals to pay for unreimbursed deductible medical expenses that exceed 7.5% of adjusted gross income. This is only accepted if the withdrawal is in the same year that the medical bills were incurred.

As per IRS Publication 590, it’s not a requirement to itemize these deductions so as to take advantage of the 10% tax penalty exception.

2. Disability

This is allowed for individuals who are totally and permanently disabled. They are allowed to access penalty-free withdrawals.

3. Health insurance premiums

IRS allows Penalty-free withdrawals for use in paying health insurance premiums (only if an individual is unemployed for at least 12 weeks).

It’s always wise to have a separate and specific bank account for receiving these transfers and use it to pay premiums only or at the minimum, have these funds pay the premium directly from the 401k.

4. Death

Beneficiaries can receive penalty-free distributions from a dead relative 401k account. However, the IRS imposes the same restrictions on spouses who inherit a 401k and opted to treat it as their own.

5. Payment of taxes

Penalty-free withdrawal is allowed if the funds are to be used to settle tax arrears.

6. Withdrawal for income purposes

Section 72(t) of the tax code allows members penalty-free access to their 401k funds to substitute their incomes (but with restrictions- take substantially equal periodic payments over time).

It’s very common with early retirees who tap their retirement accounts before Social Security kicks in.

Individuals can take annual distributions for five years (even if they are 52 or 53) or until age 59 1/2, whichever is longer.

7. Active military duty

Qualified military reservist called to active duty is allowed to make penalty-free deductions.

Early 401k withdrawal without penalty exceptions

8. Withdrawing 401k for home purchase

Withdrawal from a 401k for use as a down payment is allowed but, expects a 10% penalty.

Most 401k plans have both the loan provision and hardship withdrawal provision. The investor must first use the loan provision before going into hardship.

9. Higher education expenses

Similarly, withdrawals can be made to cover higher education expenses but will be subject to the 10% penalty.

Minimum 401k withdrawal at 70 1/2 calculator

The initial mandatory withdrawal is set on April 1 of the year an investor turns 70 1/2 (if born before July 1, 1949), followed by subsequent withdrawals every year.

Click the link below for the calculator;

https://www.investor.gov/financial-tools-calculators/calculators/required-minimum-distribution-calculator

Penalty for withdrawing 401k early

What are the penalties for early 401k withdrawal

Generally, any withdrawal from a 401k, for any reason that is made before the normal retirement age of 59 ½ attracts 10 % in income tax as a penalty (on top of taxes). But there are some exceptions that allow for penalty-free withdrawals.

Penalty-free does not mean tax-free as Withdrawals from 401k plans are taxed at ordinary income rates.

Calculate 401k withdrawal penalty

Taxes on withdrawing 401k

• If you take qualified distributions from a traditional 401k, all distributions are subject to ordinary income tax. 401k funds and distributions will be treated as taxable earnings for that year, on top of any other money that you made.
• As long as you do not take any distributions from your 401k, you are not subject to any taxation. IRS does require distributions once an investor retires (until age 73).
• Form 5329, Additional Taxes on Qualified Plans (including IRAs) and Other Tax-Favored Accounts is used To report the tax on early distributions

Tax rate for 401k withdrawal

• Distributions are taxed as regular income at the federal income tax rates ranging from 10% to 37% and are majorly determined by your other total taxable income. This is due for the tax year in which you take the distribution.
• Plan providers must withhold the mandatory 20% of the amount for distribution for tax purposes. This credit will be available when filing your taxes. You need to apply for a tax refund if it’s more than the taxes owed.
• Relevant state income tax is applicable to this income as well.
• Early withdrawal is subject to a 10% early withdrawal penalty on top of federal and state taxes. Also, your employer must withhold 20% of the amount you cash out for tax purposes.

401k withdrawal vs loan

IRS allows a maximum of $50,000 or half of your 401k plan’s vested account balance, whichever is less, and is valid for 5 years (might stretch to 15 years if the purpose is to put down a deposit for primary residence). Sometimes, employers will require a minimum loan amount of $1,000.

The debt accrues interest (at a couple of points above the prime rate), which is deducted from the paycheck on an after-tax basis.

The significant differences are;

• Withdrawal permanently hits your retirement savings while the loan must be paid back hence doesn’t affect the return.
• The amounts withdrawn early may attract the withdrawal penalty permanently and taxes are applicable

The upside of a 401k loan is:

• It doesn’t require a credit check.
• 401k loans do not appear on the credit report.
• Interest is paid to self, usually lower than a credit card.
• Minimal paperwork

Downsides:

• 401k loans from the current employer must be paid back in full within 60 to 90 days if you leave employment else the 10% early withdrawal penalty is accessed.
• You can’t borrow from an old 401k plan.

Bottom Line

A 401k early withdrawal can easily cost an investor upwards of 30% off in penalties, taxes, and other hidden costs. This is without factoring in the missed opportunity for that money to grow in your account.

Most investors will take advantage of tax reliefs provided by IRS during calamities (like COVID-19) to access their 401k. This is not good, especially if you look at it from this point of view

• The value of stocks and mutual funds tends to hit rock bottom during a crisis meaning you already have significantly less money to borrow from.
• Less principal in the account means an investor loses out on the gains from compounding interest that make long-term investing so attractive.