How To Avoid The Early Withdrawal Penalty
There are a few exceptions to the age 59½ minimum. The IRS offers penalty-free withdrawals under special circumstances related to death, disability, medical expenses, child support, spousal support and military active duty, says Bryan Stiger, CFP, a financial advisor at Betterments 401.
If you dont meet any of those qualifications, you arent entirely out of luck, though. Youve got a couple of options that may let you make penalty-free withdrawals, if youre slightly younger than retirement age or plan your withdrawals methodically.
If youre between age 55 and 59 ½ and you lose your job, the IRS will allow you to withdraw from your 401 plan penalty-free. This is called the Rule of 55, and it applies to everyone within this age group who loses a job, no matter whether youre fired, laid off or voluntarily quit. Stiger says. To qualify for the Rule of 55, the 401 you hope to take withdrawals from must be at the company youve just parted ways with. Note that the Rule of 55 does not apply to IRAs.
There is also the Substantially Equal Periodic Payment exemption, or an IRS Section 72 distribution, say Stiger. With SEPP you can take substantially equal payments from your 401 based on life expectancy. Unlike the Rule of 55, you may use SEPPs to tap an IRA early.
What Is The Standard Irs Penalty For Withdrawing 401 Funds Early
For early withdrawals that do not meet a qualified exemption, there is a 10% penalty. You will also have to pay income tax on those dollars. Both calculations are based on the amount withdrawn. So if you are in the 20% tax bracket and take out $10,000 you will owe $1,000 in penalties and another $2,000 in income tax .
Who Qualifies To Take A Cares Act 401 Withdrawal
- The account owner, their spouse or dependent must have been diagnosed with COVID-19 by a CDC-approved test, or
- The account owner must have experienced adverse financial consequences as a result of COVID-19-related conditions. For example, adverse financial consequences might include a delayed start date for a job, a rescinded job offer, quarantine, lay off, job furlough, reduction in pay or hours, a reduction in self-employment income, the closing of a business, an inability to work due to lack of childcare or other factors.
The IRS explains those qualifications in more detail in Notice 2020-50, Guidance for Coronavirus-Related Distributions and Loans from Retirement Plans Under the CARES Act.
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What Happens If You Take Out An Early Withdrawal Against Your Workplace Retirement
Unexpected hardships or emergencies may require us to think of alternative sources of getting money quickly. Sometimes this may take the form of withdrawing early from your workplace retirement plan. In some cases, withdrawing from a retirement plan may not have a major impact in others, the consequences may be significant from a financial perspective. Which consequences youll face depends on how, when, and why you tap into retirement plan funds. There are several potential outcomes when you withdraw from your workplace retirement plan early. Heres what you need to know as well as some alternatives that might be a better fit for your finances.
Disadvantages Of Closing Your 401k
Whether you should cash out your 401k before turning 59 ½ is another story. The biggest disadvantage is the penalty the IRS applies on early withdrawals.
First, you must pay an immediate 10% penalty on the amount withdrawn. Later, you must include the amount withdrawn as income when you file taxes. Even further down the road, there is severe damage on the long-term earning potential of your 401k account.
So, lets say at age 40, you have $50,000 in your 401k and decide you want to cash out $25,000 of it. For starters, the 10% early withdrawal penalty of $2,500 means you only get $22,500.
Later, the $25,000 is added to your taxable income for that year. If you were single and making $75,000, you would be in the 22% tax bracket. Add $25,000 to that and now youre being taxed on $100,000 income, which means youre in the 24% tax bracket. That means youre paying an extra $6,000 in taxes.
So, youre net for early withdrawal is just $16,500. In other words, it cost you $8,500 to withdraw $25,000.
Beyond that, you reduced the earning potential of your 401k account by $25,000. Measured over 25 years, the cost to your bottom line would be around $100,000. That is an even bigger disadvantage.
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Should You Withdraw From Your 401 Early
According to financial experts, the answer is usually no.
Taking an early withdrawal from your retirement account is a last resort, says McCarty. Why would you want to give the government even more money while, at the same time, robbing yourself of future growth on those dollars?
The money that you withdraw no longer has the opportunity to grow and compound. Imagine that you withdraw $25,000 from your 401. After taxes, the portion you get to keep will be considerably lower, especially if you have to pay the 10% penalty.
But what if you left that $25,000 in your account for another 25 years? If you have an annual return of 10%, then that $25,000 would grow to more than $270,000 during retirement.
Average 401 Balance by Age
Average 401 Balance by Age
Youd be surprised how much a retirement account can grow over time. Get in early.
If you do have to withdraw funds from a retirement account, McCarty recommends opting to first withdraw from your Roth IRA if you have one. Since youve already paid income taxes on the funds in the account, you wont pay taxes or penalties on the amount you withdraw.
How To Avoid An Early Withdrawal Penalty
You can avoid the 401 early withdrawal penalty by waiting until you are 59 ½ to take distributions from your plan. The IRS also lists various situations which could exempt you from the 10% tax, such as taking an early distribution due to a qualifying disability or reducing excess contributions. Make sure to review the exemptions list to see if your situation qualifies.
Another way to avoid the 10% early withdrawal tax is to opt for a loan against your 401 account. Your loan amount won’t be taxed as a distribution as long as:
- You borrow 50% or less of your vested balance up to $50,000.
- The loan is repaid within five years .
- Your payments are substantially level.
- Payments are made at least quarterly over the life of the loan.
While 401 loans can be a good alternative, not all plan providers offer them so you’ll have to check to see if it’s an option for you.
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An Early Withdrawal From Your : Understanding The Consequences
OVERVIEW
Cashing out or taking a loan on your 401 are two viable options if you’re in need of funds. But, before you do so, here’s a few things to know about the possible impacts on your taxes of an early withdrawal from your 401.
For information on the third coronavirus relief package, please visit our American Rescue Plan: What Does it Mean for You and a Third Stimulus Check blog post.
Do You Pay Social Security Tax On Ira Withdrawals
In most ways, money you take out of your IRA is just like your wages. … The big difference is that you don’t pay FICA taxes on your IRA withdrawals. That means you don’t pay Social Security and Medicare taxes on your IRA withdrawals. Also, you can withdraw as much as you want, and still not owe the FICA taxes.
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What Happens If I Stop Contributing To My 401k
If you are considering stopping contributions to a 401k, you would be better served to merely suspend those contributions. A short-term suspension will slow the performance of your retirement fund, but it wont keep it from growing. It also will lessen the temptation to simply withdraw all the funds and wipe out retirement savings in the process.
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Your SEPPs use one of three calculation methods, factoring in your account balance, a “reasonable interest rate” and you and the account beneficiary’s ages.
While the IRS previously capped interest to match the previous two months’federal mid-term rates, you can now use a higher rate of 5%, according to new guidance, significantly boosting payments.
For example, let’s say you have a $1,000,000 account balance and you’re age 50 with a 45-year-old spouse who is the beneficiary. For January 2022, the rate was 1.56%, for a maximum SEPP distribution of $36,151 per year. However, the new 5% rate boosts the annual payment to $59,307.
“It works fine as long as the client understands they need to maintain that exact draw for the required time,” Farrar said.
However, if you don’t follow the rules, you’ll owe a 10% penalty on all of your payments, with possible underpayment fees and interest.
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Repercussions Of An Early 401 Withdrawal
The IRS sets the rules around retirement savings. There are limits to how much tax-deferred income you can deposit into different retirement accounts per year, what accounts you can put pre-tax dollars in, what accounts you can put after-tax dollars in, even when you can access your money.
Fail to follow these rules, and you could face huge penalties and other expected costs.
Option #: Open An Inherited Ira: Ten Year Method
| Account type | The assets are transferred into an Inherited Roth IRA held in your name. |
|---|---|
| Money is available | At any time up until 12/31 of the tenth year after the year in which the account holder died, at which point all assets need to be fully distributed. |
| Other considerations |
|
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Option #: Spousal Transfer
| Account type | You transfer the assets into your own existing or new IRA. |
|---|---|
| Money is available | At any time, but earnings generally will be taxable until you reach age 59½ and the five-year holding period has been met. |
| Other considerations |
|
How To Withdraw 401k Money
As with any decision involving taxes, consult with your tax professional on considerations and impacts to your specific situation. An Edward Jones financial advisor can partner with them to provide additional financial information that can help in the decision-making process. When considering withdrawing money from your 401 plan, you can withdraw in a lump sum, roll it over or purchase an annuity. Your financial advisor or 401 plan administrator can help you with this.
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Is It Better To Be Fired Or To Quit
CON: Quitting can make it harder to pursue legal action later. If you want to pursue a wrongful termination or retaliation claim against your employer, it’s going to be much harder to do that if you quit voluntarily, Stygar noted. If you leave willfully, in a lot of cases, you forfeit those claims.
Withdrawing From Your Account
When youre in need of financing, it may seem like withdrawing from your workplace retirement plan is a viable option. After all, your retirement savings account may seem like a prime source of money when you need it in a pinch. Its not ideal to pull from these funds early, however. Nor is it as straightforward as selling equities in your portfolio.
To withdraw from a workplace retirement plan, you must first qualify for a hardship withdrawal. Hardship withdrawals are available to people with specific financial needs as defined by law.1 These include:
- College tuition payment for yourself, your spouse, dependents, or non-dependent children
- Payments to avoid foreclosure or eviction from your home
- Funeral and burial expenses for parents, spouses, children, or dependents
- Medical bills not reimbursed by your insurer for you, your spouse, or dependents
- Down payment or, in some cases, repairs to your principal residence
If you decide you take a hardship withdrawal, you may not be able to contribute to your workplace retirement plan for six months or more. The IRS also prohibits you from withdrawing more than you need to cover the hardship plus local, state, and federal income taxes or penalties.
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Taxes On 401 Withdrawals
The early distribution penalty isnt the only cost youll have to worry about when you withdraw funds early from your 401. Youll also pay income taxes on your withdrawals. In fact, taxes apply when you take money from your 401, regardless of whether its an early withdrawal.
The amount of taxes youll pay on your 401 distributions depends on your income tax rate, since these distributions are taxed as income. Here are the income tax brackets for the 2022 tax year.
| Tax rate |
|---|
What Is The Tax Penalty For Withdrawing Money From A 401
It depends on when you make the withdrawal. If you are age 59 1/2 or older, then there is no tax penalty. However, if you make a withdrawal before reaching this age, you will be charged an extra 10% penalty on top of your regular income taxes that you pay on the funds. In some cases, you might be able to take a withdrawal without being required to pay the penalty. Some situations include hardship withdrawals, unreimbursed medical expenses, education related expenses, qualified reservists, and death. This is not an exhaustive list, and you should contact your financial planner to discuss your specific situation to see if you can qualify for a penalty-free withdrawal.
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How Much Is 401 Early Withdrawal Penalty
The penalty for unexempt early withdrawals from your 401 is a 10% tax on the distribution amount.
You must report the 401 distribution on your tax return for the tax year in which you made the withdrawal.
The amount must be included in your total tax balance due or refunded to you.
For example, if youre a 35-year-old single filer and youve earned $60,000 by 2022, your tax rate will be 22%.
If you take a $20,000 401 distribution, you add $20,000 to your income for the year, which can affect your taxes.
In this case, you still fall into the 22% tax category. As a result, you will owe $4,400 in distribution taxes and an additional $2,000 in 10% early distribution tax.
In total, the early distribution will cost you a whopping $6,400, leaving you with a net worth of $13,600.
Its usually best to keep your 401 funds in the account until retirement. This will potentially increase it to earn interest on the account and avoid large tax penalties.
However, in some situations, rolling over some or all of your 401 may be the best option available. If so, make sure you understand what expenses you can expect and how distributions will affect your retirement income.
Living With A Disability
If you become totally and permanently disabled, getting access to your retirement account early becomes easier. In this case, the government allows you to withdraw funds before age 59½ without penalty. Be prepared to prove that youre truly unable to work. Disability payments from either Social Security or an insurance carrier usually suffice, though a doctors confirmation of your disability is frequently required.
Keep in mind that if you are permanently disabled, you may need your 401 even more than most investors. Therefore, tapping your account should be a last resort, even if you lose the ability to work.
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How 401 Hardship Withdrawals Work
The IRS allows anyone to take penalty-free withdrawals if they have an “immediate and heavy financial need.” You can use the money to cover your needs or those of someone else.
You may qualify for a hardship distribution if the funds go to:
- Pay for certain medical expenses
- Buy a primary residence
- Cover college tuition, fees, room, and board
- Prevent eviction or foreclosure
- Pay for burial and funeral expenses
- Make necessary home repairs after a disaster
The amount you’re able to withdraw will be limited to the amount necessary to cover the expense.
Substantially Equal Period Payments
Substantially Equal Period Payments might be a good option if you need to withdraw money for a long term need. These payments must last a minimum of 5 years or until you reach the normal 401k withdrawal age of 59 1/2, whichever is shorter. For this reason, this is not a good option if you have a short term need like a sudden unexpected expense. You cannot withdraw funds under this method if you still work for the employer through which you have the 401. To calculate the amount of these payments, the IRS recognizes three acceptable methods.
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