401(k) Early Distribution Tax Penalty

BILL'S ANSWER

Congress and the IRS call withdrawals from a 401(k) or other qualified retirement plan a distribution. In general, if you take a distribution from a traditional individual retirement account such as a 401(k) or other qualified retirement plan before you turn age 59½, you are subject to a 10% penalty tax. The taxable amount is added to your taxable income. Put another way, the 10% penalty tax is in addition to your regular income taxes. Please note that the associated penalties and taxes are applied at the time of your withdrawal transaction, so even if you plan to gift the proceeds later on, you will still be liable for the penalties and applicable taxes.

All 401(k) Distributions Are Subject to Income Tax

You can avoid this additional tax penalty if you meet certain criteria, but you cannot avoid including your retirement withdrawal from your taxable income. Some distributions can be made without penalty, but these usually require a financial hardship. I will provide more information about 401(k) hardship-based distributions in a moment.

Here is more information about hardship-based distributions.

Hardship Withdrawals

Hardship withdrawals, called "distributions," are permitted from 401(k) plans. They are subject to applicable income taxes and a 10% early withdrawal penalty if you are younger than 59½.

Financial hardship withdrawals are allowed for the following reasons:

• To buy a primary residence
• To prevent foreclosure or eviction from your home
• To pay college tuition for yourself or a dependent, provided the tuition is due within the next 12 months
• To pay un-reimbursed medical expenses for you or your dependents

Early Withdrawal Penalty Exceptions

You may qualify to take a penalty-free withdrawal, but are still subject to income taxes,  if you meet one of the following exceptions, consistent with Section 72(t) of the Internal Revenue Code:

• You become totally disabled.
• You are in debt for medical expenses that exceed 7.5% of your adjusted gross income.
• You are required by court order to give the money to your divorced spouse, a child, or a dependent.
• You are separated from service (through permanent layoff, termination, quitting or taking early retirement) in the year you turn 55, or later.
• You are separated from service and you have set up a payment schedule to withdraw money in substantially equal amounts over the course of your life expectancy. (Once you begin taking this kind of distribution you are required to continue for five years or until you reach age 59½, whichever is longer).

See the IRS documents 401(k) Resource Guide - Plan Participants - General Distribution Rules and Publication 575 to learn more about 401(k) distribution rules.

Consult With a Tax Professional

Speak with both the 401(k) plan administrator and a tax professional to make certain that you understand your total tax obligations. I have seen many people who thought they had accounted for all taxes owed, only to find out that they owed a lot more, once the return was prepared. For instance, a large 401(k)withdrawal can raise the total income for the year to the point where the taxpayer falls into a higher income tax bracket. When that happens, the amount that the taxpayer was having withheld from his or her regular paychecks may prove to be insufficient to cover the tax obligation at the new, higher tax rate.

Even worse, if a person files an incorrect return, understating the taxes owed, it may take years for the IRS to catch the error. Once the IRS does correct the error, it is the taxpayer who will owe the taxes plus years of interest and penalties.

I hope this information helps you Find. Learn & Save.

Best,

Bill

Bills.com

Comments (269)

Joseph T.
Cumru Township, PA  |  February 01, 2012

Bill, My wife was laid off 3 years ago and in 2011 we closed out her 401k (abt $34k) to keep paying the mortgage and doctor bills. She is currently 59 and I am 55. We paid the 20% taxes when we withdrew the money and was wondering if there is a way to reduce the 10% penalty. It's not a lot, about $2400, but that would cover almost two months of mortgage payments. Thank you for the advise.

(0)

Bills.com
February 01, 2012

See IRS 401(k) Resource Guide - Plan Participants - General Distribution Rules for a discussion of the medical exception to the 10% tax rule. Also, was your spouse age 59½ or older when the distributions occurred? If so, the 10% tax does not apply.

(0)

Joseph T.
Cumru Township, PA  |  February 01, 2012

Thank you for the response, unfortunately she was not 59½ yet.

(0)

Ron B.
New York, NY  |  January 27, 2012

Hi, I was laid off in February 2011. At the time I owed $16k to pay my 401k loan. The 401k company used to deduct the loan amount monthly from my paycheck. Once I was seperated, I was given 90 days to pay off my entire loan in full or face penalty and would treat this loan as taxable income. For the next 4 months I was out of work and couldn't pay off my loan. So now that I am preparing to do my taxes for 2011. I am stuck with 16k taxable income. I am not sure about the 10% penalty. Could I avoid the 10% penalty because of hardship and I was out of work. THanks a lot Ron A

(1)

Bills.com
January 29, 2012

Being out of work is not enough to cover the hardship requirements, as set down by the IRS. The non-penalty hardship cases are most stringent. I recommend that you confer with your tax professional regarding your total tax obligation for 2011.

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K M.
Pahrump, NV  |  January 25, 2012

I'm 61, unemployed and homeless for two years. Cashed in my 401K to buy a foreclosure home. Do I have to pay income tax on the withdrawal? What if I don't have money for 35% taxes? Thanks so much. I thought unemployment was scary. Facing taxes is much worse!

(0)

Bills.com
January 26, 2012

If you had a traditional 401k retirement account, then your withdrawal is taxable income. A Roth account, that has funds deposited after tax was deducted, is not taxed on withdrawal. I recommend that you speak with a tax expert to see what are your tax requirements. Also, check the tax rate that you are paying, as 35% sounds too high.

(0)

Amber S.
Grand Junction, CO  |  January 25, 2012

I was recently let go from my employer. I had a 27k 401k loan balance. As i have no way of repaying the loan am i smart to just cash the whole thing out to avoid paying penalties twice?

(1)

Bills.com
January 25, 2012

If you do not repay the loan, then that sum will be considered a distribution and you will have to pay the taxes and penalties for the withdrawal. For more information read the Bills.com article about 401K loans. Try to avoid taking a distribution from your 401k account.

(0)

Bills.com
January 25, 2012

If you do not repay the loan, then that sum will be considered a distribution and you will have to pay the tax and penalties for the withdrawal. For more information read the Bills.com article about 401K loans. You will want to avoid taking out money from your 401k if you will incur penalties.

(0)

Jai L.
Fort Worth, TX  |  November 04, 2011

My son was diagnosed with brain cancer in oct 2010. At the time I was paying child support. He had to come live with me and I was unable to work regularly because of his treatment schedule. I had 2 401ks from 2 different past employers both under 3 thousand dollars one was refunded without tax penalty the other now says that it has to be moved or withdrawn. My mortgage is behind and I would like to withdraw the second without penalty. Does financial hardship due to time off for cancer care qualify for deferrment of the extra penalty tax?

(0)

Bills.com
November 04, 2011

Foreclosure prevention does not exempt a person from the 10% penalty. However, if you are incurring medical care up to the amount allowable as a medical expense deduction then the distribution is tax-free. Follow the link above to the 401(k) Resource Guide - Plan Participants - General Distribution Rules and see the subsection entitled "Tax on early distributions."

(1)

Frank R.
B/o Stratford, NJ  |  November 01, 2011

Hi Bill, Last year I took at 25K loan against my 401K. The payment schedule is over 5 years. However, things have changed at my job and I would like to seek employment elsewhere. I contacted the company (not the plan administrater at my office) and they told me that they only way I can pay down the loan is in-full. There are no exceptions... I can't increase my payments to pay off in a year, etc. Needless to say, I don't have the 20K remaining and can't pay it off. Is my only option to take the distribution so I am not "handcuffed" to my current job? Are all retirement service-providers like this? Or, is this a unique rule with mine? Please advise as leaving my current job would also mean substantial increase in earinings. I'm 48yo. Thank you.

(0)

Bills.com
November 01, 2011

Alas, the rule your 401(k) administrator quoted is not unique. It is found in 29 CFR 2550.408b-1 - General statutory exemption for loans to plan participants and beneficiaries who are parties in interest with respect to the plan. In general, 401(k) participants may borrow up to 50% of their vested amount or $50,000, whichever is less. If repaid on time, the loan is free from taxes and penalties. A typical interest rate is prime or prime plus one percent. Most plans have a five-year repayment window, and if the borrower leaves the employer before the loan is repaid, the borrower must make the payment in full within 30 to 90 days.

If the borrower ceases employment and does not repay the loan, or simply does not repay the loan, the loan is treated as a distribution and is taxed as such.

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John E.
Tempe, AZ  |  October 28, 2011

I currently have a vested 401k account in the amount of $20k, I took out a loan of $5500 but now I have to move to a diffirent state, would I be able to withdraw the remaining $15k?

(1)

Bills.com
October 28, 2011

Discuss your plan's distribution rules with your 401(k) plan administrator. Consider rolling your balance into an IRA, which will result in no negative tax impact for you.

(0)

Angela C.
Taylor, PA  |  October 24, 2011

I have a vested 401k from my previous employer currently valued about $20,000. Due to worsening symptoms from an onset medical condition, I was no longer able to meet all of the job requirements of my position and my employer was unable (or unwilling) to provide the 'special accommodations' requested by my physician; therefore I was let-go (if that's the correct term) but eligible to collect unemployment compensation (UE) (the amount approximately 1/2 of my regular salary). After all of the approved Tiers & extensions, my UE comes to an end in two weeks. Because of my medical condition, it has been more difficult for me (vs. the general unemployed population) to find employment, and although I have over 30 years of experience, I do not have a college degree. My medical symptoms have gotten worse, with frequent unpredictable and acute onsets, where I become completely incapacitated, sometimes for days. I am considering filing for disability, as it is probably my only option (and honestly not one I'm thrilled about - the compensation will be close to poverty level, with shoddy health coverage, if any (not good when you have multiple health conditions) as well as the "mandatory" 2-3 year wait, and all the red tape that comes along with it. (Sad to think that SS is money that I EARNED, that came out of MY paycheck the past 30 years, yet still have to battle the gov't. for it when it's desperately needed...). Anyway, my question is, if I wanted to close out my 401k account within the next month or so (after putting in my application for SSI -- if that matters), to pay rent & bills & medical care, etc., will I still be taxed and penalized the full percentage amounts, even with the (lower) UE wages received in 2010 & 2011 and my medical condition/disability (and also receiving ZER0 income, which will be the case when my UE ends)? Would I qualify for any exceptions? (I wish the law would change for 401k's of lower value's like mine (e.g.: under $30,000), where they would ease up on penalties for withdrawing or closing small (& inactive -- I haven't added to it in 2 years) accounts due to hardship! Wishful thinking, I suppose. Thanks.

(0)

Bills.com
October 24, 2011

See the link in the original answer above to the IRS Web page that contains information about the 401(k) distribution guidelines. You may qualify for a medical hardship, or a hardship based on what I guess may be an inability for you to pay your rent or mortgage.

(0)

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