How to Avoid IRS Tax Penalties for a 401(k) Early Withdrawal

By saving consistently over the long term, you probably will accumulate a large sum of money in your 401(k) plan at work. This money is designed to be a nest egg for your retirement, and to discourage tapping into the funds, the Internal Revenue Service assesses a 10 percent penalty if you withdraw from the account before retirement age of 59 1/2 years. In certain cases, you may avoid the penalty, depending on the type of withdrawal that you are making from the account.

Hardship Withdrawal

You can withdraw from your 401(k) without incurring penalties in case of certain economic hardships. If you have unreimbursed medical bills that exceed 7.5 percent of your adjusted gross income, you can withdraw the excess penalty-free. You can also withdraw penalty-free if you are using the money to pay federal income taxes, or if you are totally disabled.

Rollover to IRA

You can roll over money from a 401(k) to an individual retirement account and not only avoid the penalties but also avoid paying taxes on the money as well. Arrange for a direct transfer from the trustee of your 401(k) plan to the trustee of your IRA. Then, the trustee of the IRA will handle all of the details and paperwork and also receive the money and deposit it into your account, all with minimal effort on your part.

Loans

If your 401(k) plan allows for loans, this may help you avoid penalties and taxes. When you borrow from your account, you arrange to repay the money over a certain period, with interest that you pay to yourself. One problem with a 401(k) loan is that if you leave your employment, the entire loan amount generally becomes due and payable within a short time. If you cannot pay it back, you may end up paying both taxes and penalties on the outstanding loan amount.

Substantially Equal Payments

Section 72(t) of the income tax code allows you to withdraw money from a retirement plan before retirement age, but with some guidelines. You must take substantially equal payments over a certain period, usually a minimum of five years. You pay the taxes on the withdrawal but avoid the penalties. This is good if you want to retire early and need the income. You can also structure the withdrawals over your life expectancy and avoid the penalties. In some cases, your plan will not allow you to take this option while you are still working.