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Penalty for Early Withdrawal of 401k

Penalty for Early Withdrawal of 401k

Many people end up withdrawing their 401k funds prematurely owing to their financial needs. Due to this early withdrawal, the government imposes a penalty on you. Yet there are some exceptions to the penalty on early distribution of 401K, which have been enlisted here.
Arjun Kulkarni
A 401k retirement plan ensures that once you are old and your sources of income have dried up, your finances will still be ably propped up by the money you intelligently put aside. But of course, there will be times and circumstances when you are left with no option to go and withdraw the money you were setting aside for the future. Now, if you withdraw the money before you turn 59½ years old, you will be liable to pay the penalty, besides the taxation on your income. So if you're imagining that a $30,000 withdrawal from your 401k means that the whole sum will land on your lap, you're terribly mistaken. Let us see both the components which will bite a sizable chunk of the money you withdraw.
Penalty Component
The penalty component in the rule for 401k early withdrawal penalties means that out of the money you withdraw, you will have to pay 10% as a penalty. So taking the above-mentioned example of a $30,000 withdrawal forward, it means that you will have to pay a penalty of 10% of the amount: $3,000.
Tax Component
Now, since you weren't charged the tax when the money went into the account, you will be charged when it comes out of it. The way the IRS sees things, the money which comes out of the 401k account amounts to being a 'source of income' and will be taxed accordingly. And by how much? It will be taxed according to which tax bracket you fall under for the year that you file taxes for. So if you fall under the 20% tax bracket, then the money you withdraw, $30,000 in the above case, will be taxed at 20% and you will be receiving $6,000 less.
Secondly, if there are any state income taxes, you will have to pay those as well. So basically what with the penalties and the taxes you have to pay, you will end up having an amount in the region of $20,000, which to put things into perspective means that you have lost about 1/3rd of the amount you wanted to withdraw in the first place. So clearly, one can say that if so much of the withdrawal amount is going to be shaved off, you'd rather not withdraw that money at all.
Exceptions
Of course, the rules are nice enough to understand when you have a genuine hardship to contend with. Which is why it relieves you of the extra 10% penalty in the following cases.
  • Direct rollover to a new retirement account
  • Permanent or total disablement before the age of 59½
  • Payment of medical insurance following an unemployment period of 12 weeks or more
  • First time home buyer, where the penalty is waived off on the first $10,000, but has to be paid on the remainder of the withdrawal.
  • You can, within boundaries, pay for your spouse's, children's or grandchild's higher education, within specific rules that you can find under Internal Revenue Service article Notice 97-60.
Certain situations in life arise when finances are tight and the banks are unyielding, you may be tempted to break the glass door which protects your retirement planning. Ensure that you explore other financing options apart from borrowing against 401k, else you would want to withdraw under the above-mentioned exceptions.