How Does the 10% 401(k) Tax Penalty Work?

by Gregory Hamel

    Contributing money to a 401(k) plan can save on taxes, but tax-advantaged accounts are subject to a variety of regulations that can limit your access to funds. Taking money out of a 401(k) too early can result in a 10-percent tax penalty, which may complicate early retirement planning and financing large expenses. It is possible to avoid the early withdrawal penalty on certain types of withdrawals and through 401(k) loans.

    Early Distribution Basics

    The Internal Revenue Service imposes a 10-percent early distribution penalty on funds you take out of a 401(k) plan before you reach the age of 59 1/2. Tapping into a retirement account too soon increases the chances of running out of retirement savings money later in life. The early withdrawal penalty gives 401(k) investors incentive to wait longer to access funds, thereby reducing the chances of running out of money during retirement. You have to pay normal income taxes on 401(k) distributions regardless of when you withdraw funds.

    Penalty Exceptions

    You can withdraw funds from a 401(k) plan before the age of 59 1/2 without penalty if the distributions are made in certain special circumstances. According to the IRS, circumstances that can qualify you for penalty-free distributions include disabilities, natural disasters, IRS levies, and death. You can also take penalty free withdraws to reduce excess contributions and for the unreimbursed medical expenses that exceed 7.5 percent of your adjusted gross income.

    401(k) Loans

    Rules that govern 401(k) plans vary from one employer to another. Some plans offer the option of taking loans from 401(k) funds, which allows you to access savings without paying the early withdrawal penalty. The IRS says that you can generally borrow up to 50 percent of your 401(k) balance, up to a maximum of $50,000, and the loan must be paid back within five years unless it is used to buy a primary residence.

    Considerations

    The early withdrawal penalty also applies to traditional Individual Retirement Accounts. A traditional IRA is a type of retirement account you can open on your own, through a financial institution such as a bank, mutual fund company, or stock brokerage, that offers tax-deductible contributions and tax-deferred investment gains, similar to a 401(k) plan. You can withdraw contributions from a special type of IRA called a "Roth IRA" before age 59 1/2 without penalty, but contributions to Roth IRAs are not tax deductible. In addition, you can't contribute to a Roth if you make more than $125,000 a year as single taxpayer or $183,000 as a married person filing a joint tax return for the 2012 tax season.

    About the Author

    Gregory Hamel has been a writer since September 2008 and has also authored three novels. He has a Bachelor of Arts in economics from St. Olaf College. Hamel maintains a blog focused on massive open online courses and computer programming.

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