Early Withdrawal Penalty from 401K Distribution

Recent data suggests that an overwhelming majority of Americans (70%) regularly contribute to a 401(k) retirement plan. Are you one of them? If so, then it makes sense to consider that money as well earned and deserved. Unfortunately, that doesn’t mean that your money will be available to you whenever you want. 

To encourage saving for retirement, 401(k) plans are designed to remain untouched until the accountholder turns 59 ½ years old. Because the contributions are tax-free, an early withdrawal will lead to penalties and other consequences. Learn more about the early withdrawal penalty from 401(k) accounts and how it could impact your finances below.

401(k) Retirement Funds: A Brief Overview

We know what you’re thinking – if there’s a penalty for withdrawing your own money from a retirement account, then what are the advantages of having a 401(k) to begin with? While most 401(k)s do follow the 59.5 years of age rule, there are still many reasons to invest in this type of retirement strategy. Here are just a few of the main benefits of a 401(k) investment account:

• Your employer often matches some or all of your contributions.
• There are high contribution limits, so you can save significant amounts.
• Provides a safe shelter from creditors.
• Contributions are taken from your check pre-tax, which lowers your taxable income in the year you make the contribution.
• You can control the level of your contributions.
• Your money grows over time.
• You can choose from a range of investments with differing levels of risk and reward in your 401(k) account.

With these advantages in mind, it can start to make more sense why so many Americans are currently contributing to these plans.

What are Early Withdrawal Penalties?

There may be times of financial need, however, that require you to take out money from your 401(k) savings account. You are in full control of your account, so you can make a withdrawal if you want. You do not need a specific reason or documentation to decide to take your own money out. 

You will experience early withdrawal penalties, though, if you take out money before you turn 59 ½. Typically, early withdrawals are subject to regular income taxes and an additional 10% fee.

Who Charges Early Withdrawal Penalties?

The 10% additional tax on your 401(k) funds is levied by the IRS. The IRS is also the agency that will tax the income you take out of your 401(k). The IRS’s authority was established through congressionally mandated power, which gives the Secretary of the Treasury the full authority to administer and enforce internal revenue laws. The IRS was created to enforce and administer these laws, so the agency maintains the power to charge penalties on income.

Tax Implications of Early Withdrawals

Early withdrawals will be considered taxable income. That means you must report the amount you withdraw as ‘income’ when you file taxes in the year you withdraw the money. You’ll also be subject to an additional 10% fee on the money.

Exceptions to the Early Withdrawal Penalty

There are not many tax strategies you can utilize to avoid an early withdrawal penalty unless you simply do not take money out of your 401(k) until after you turn 59 ½. There are a few exceptions, though, that can help you avoid paying the penalty. 

The IRS allows you to withdraw money from your 401(k) before turning 59 ½ penalty-free under these circumstances:

• You’ve suffered an accident and are now on total and permanent disability
• You have a medical expense that’s greater than 7.5% of your adjusted gross income and it is not eligible for reimbursement.
• You were separated from service at age 55 or older, and if so, you can make early withdrawals without penalties from the plan at the job you’re leaving.

Just recently, a new law was passed that allows for even more exceptions. This bill went into effect at the start of 2024 and allows penalty-free withdrawals under the following circumstances:

• You’re residing in a declared national disaster area (You will be eligible to withdraw up to $22,000).
• You are experiencing a sudden financial emergency (You can only use this reason to withdraw up to $1,000 once a year).
• You are going through a domestic violence situation (You can withdraw up to $10,000 or 50% of your account if that is less than $10,000)
• You were recently diagnosed with a terminal illness (You can withdraw any amount if the disease is likely to cause death within 7 years).
• You can withdraw up to $2,500 per year without penalty if you’re paying for qualifying long-term-care insurance premiums.

What is the Age 59 ½ Rule?

The age 59 ½ rule is another term that describes the early withdrawal penalty. This phrase is often used because the cut-off age for penalties is set at 59 ½. The U.S. government is the agency that determines the cut-off age.

Exceptions to the 59 ½ Rule

There are some 401(k) plans that allow greater flexibility than the general exceptions to the 59 ½ rule allowed by the IRS. Depending on your specific plan, you may be allowed to make minor withdrawals that will be considered hardship distributions. You’ll have to read through the details of your specific plan or talk with your HR coordinator to see if these withdrawals apply to your situation. 

Typically, though, a hardship distribution will apply in the following situations – when you’re facing eviction or foreclosure, you’re enduring medical or funeral expenses, or your primary home was damaged and in need of repair.

The Notification and Payment Process

Are you not sure where to make your early withdrawal penalty payment? Are you unsure if you even owe the IRS a penalty at all? Below, we’ll go over exactly how you’ll get informed and how to make a payment.

How You’ll Be Informed About Your Penalty

When you request an early withdrawal from your 401(k), your plan administrator will withhold this penalty when they make the distribution. In some cases, they may also withhold income tax. At the end of the year, the plan administrator will issue you a 1099-R form showing your withdrawal, the penalty, and any income tax withheld. 

Common Challenges of Early Withdrawals

Sometimes, an early withdrawal can increase your tax liability to the point that you end up with an unexpected bill. The best way to handle the situation is to pay off everything you owe right away, but that’s not always a possibility. If you are facing an unpaid tax liability, then don’t hesitate to contact a tax attorney about your options. 

In most cases, the IRS will be willing to work with you. Together, you can come up with a payment arrangement that works for both parties. Another challenge you might face is not being sure how to go about the process. 

The Financial Strain of Unexpected Penalties

If you have to unexpectedly withdraw some of your 401(k), then it’s safe to say that you’re already experiencing an unexpected financial strain. That said, the additional 10% penalty can cause even more stress on you. Unfortunately, unpaid taxes can quickly balloon into an even higher amount if you don’t address them promptly due to compounding interest and late fees.

What Happens if You Cannot Pay Immediately?

If you cannot pay off your full balance right away, then it’s important to get in touch with a tax representative or the IRS about your options. Without action from you, the IRS may continue to charge fees and penalties and pursue more intense collection efforts. 

If you work with the agency, then you’ll likely be able to set up a payment plan. This type of arrangement is beneficial for both you and the IRS. The IRS won’t have to continue investing resources in tracking down payments, and you don’t have to worry about collection efforts unless you later miss a payment.

How to Avoid Early Withdrawal Penalties

If you don’t qualify for one of the exceptions noted above, one way to avoid early withdrawal penalties is to investigate your options for borrowing money instead of simply taking it out of your account. Many 401(k) plans have the option of letting you take a ‘loan’ out of your 401(k) funds. Once you have the money, you’ll begin paying it back in increments with every paycheck.

This type of strategy has a few benefits. For one, the loan you take out on the 401(k) won’t generate taxable income like a withdrawal. When you withdraw funds, you must pay general income tax on the sum, but when you borrow the money, it’s considered tax-free. 

One setback of this strategy is that your payroll deductions will be automatic. While your 401(k) will continue to grow, the income you actually get to take home every week will get smaller.

Consider Other Resources Before Tapping into Your 401(k)

One of the best ways to avoid early withdrawal penalties is to avoid tapping into your 401(k) at all costs. When possible, consider your other resources first. Paying a 10% fee on your withdrawal is quite hefty, so you may be able to get a better deal by taking out a private loan or borrowing from elsewhere.

Roll Over Strategies

Another option you have is to use a rollover strategy. Typically, when you take money out of your 401(k), the IRS will give you up to 60 days to roll the funds over into a new IRA, 401(k) plan, or retirement account. If you make the transfer within that time, then the IRS won’t charge you the 10% fee.

Do You Need Tax Help After Getting Hit with 401(k) Penalties?

Have you recently incurred a 401(k) early withdrawal penalty? Here at Damiens Law, our team of tax resolution lawyers can help you fully understand your tax situation, review your options with you, and assist you in making an informed decision on how to move forward with your 401(k) early withdrawal penalty.

Schedule a consultation with our team at Damiens Law now to discuss your specific financial situation and work on getting back in good standing with the IRS as soon as possible.