The tax law inflicts a 10% penalty on certain distributions or early withdrawals, from 401k retirement plans. Yet, 401k withdrawal rules also state that higher education expenses, hardships and buying a first home are some instances that qualify for a waiver of the penalty on early distribution or withdrawal.
During an emergency, a pension or retirement account can be a source of liquidity even though, ideally, an individual should not try to touch it. To encourage families to save money towards retirement, the Federal government put into place certain pension plans such as IRAs and 401k. Hence, it only makes sense that the government discourages the use of 401k or other such pension funds for purposes other than retirement. Yet there are instances when investors can tap their retirement funds without incurring 10% penalty.
401k Withdrawal Applicability Rules
Usually, the government makes it very difficult for anyone to make 401k withdrawals if they are below 59.5 years of age. There are a few exceptions to this rule and these exceptions that make you applicable for a 401k withdrawal, are as listed below.
- To pay off yours or family member’s large medical bills.
- To make a down payment on residential property. The rules for home purchase consider such a withdrawal reason as valid.
- To stall or prevent a foreclosure on house or other property.
- To pay for the college fees of a child or a spouse.
Though such immediate cash requirements that have valid reasons, allow for 401k hardship withdrawal, the IRA rules state that on availing such a 401k withdrawal, the person is not allowed to make any annual 401k contributions for at least 6 months thereafter.
Considerations at the Time of 401k Withdrawals
When looking at the withdrawal rules, one can easily see that there are several considerations that one needs to make when thinking of making 401k withdrawals. One of the biggest things to consider are the penalties, i.e. tax penalties. Not only the amount withdrawn be charged as a normal income under whatever tax bracket the individual falls, but there is also an additional 10 percent penalty on the amount withdrawn. In certain circumstances, the IRA waives off the 10 percent tax penalty on 401k withdrawals and the circumstances are listed below.
- When the withdrawal is made by the family of the deceased 401k plan holder.
- When the 401k plan holder suffers a total and permanent disability.
- When the employee with the 401k plan retires, resigns from his job or is sacked from his employment.
- When the employee has reached or crossed 55 years of age.
- When you make a 401k withdrawal that is less than the maximum allowable amount for a medical expense deduction.
- When the employee begins equal or substantially equal periodic payments post withdrawal.
- When the withdrawal is made due to a qualified domestic relations order.
It is essential to note that as every 401k plan has annual contribution limits on the amount of money you put into the plan, you are not allowed to make up for any withdrawals that you have made from it. This leaves you with one thing to note, a 401k withdrawal should be your last possible option to get money no matter how bad your financial need is. If it can be postponed, it definitely needs to be. In fact, even a 401k loan is preferable to a 401k withdrawal when it comes to all the pros and cons of it.
401k Withdrawal Options on Employment Termination
There are three basic cases to consider at the time of 401k withdrawals at the time of employment termination.
You are Over 59.5 but Below 70.5 Years of Age
You can either withdraw in a lump sum net of an IRA mandated 20% withholding tax, you can leave the amount with the previous employer till you actually need it or you can do a 401k rollover into an IRA account or get a solo 401k to start up your one person business maybe.
You are Under 59.5 Years of Age
Once again you can take a lump sum in withdrawal, of course after the 20% mandatory withholding tax is cut. You will also be charged with the 10 percent tax penalty unless of course you fall in the ‘401k penalty free withdrawals’ exceptions. Alternatively, you can also either leave the amount with your previous employer till the need arises or you can do a 401k rollover or a solo 401k stunt.
Withdrawal from your retirement funds is a big decision, and before tapping into this fund discuss the situation with a tax adviser, lender, or financial consultant to see if a less expensive alternative exists. Till then, plan your withdrawals only after being fully aware of the 401k withdrawal regulations that affect your decision.