401k Withdrawals

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401k Withdrawals

In this article we're going to be discussing 401k withdrawals. This includes early withdrawals, and allowed distributions under the current 401k rules. We're also going to discuss the potential tax penalties for early withdrawals.

Remember, pension plans such as IRAs and 401k plans were put into place by the government to encourage families to save money towards retirement. So it only makes sense that the government discourages the use of 401k funds for purposes other than retirement. In fact, the tax law imposes an additional 10% on certain early withdrawals, or distributions, from these funds.

Early 401k Withdrawals

An early 401k withdrawal involves any money withdrawn from your accounts before reaching the age of 59 1/2. This particular withdrawal rule is not unique to 401k plans, but also applies to:

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A qualified employee annuity plan
An IRA that is not an educational IRA
A qualified employee plan / 401k plan
A tax sheltered annuity plan - such as a 403b plan that applies to employees of public schools or other tax exempt organizations.

If the withdrawal is taxable - which is usually the case with a large share of 401k funds - not only do you have to report this as income on your federal income tax return, but you are also subject to an additional 10% penalty.

401k Rollover Withdrawals and Distributions

The IRS does not impose a penalty on 401k withdrawals or distributions that you intent to roll-over to another retirement plan. The investment is still serving its intended purpose - retirement income.

401k Rollovers

From the IRS's perspective, a 401k rollover occurs when you withdraw cash, or other assets, such as stocks, bonds, and mutual fund shares from one qualified employer's 401k plan and contribute all or part of it into another 401k plan, a qualified retirement plan, or a traditional IRA within 60 days.

Allowable 401k Distributions

For 401k plans, and all other qualified retirement plans, the IRS also allows for penalty-free withdrawals that fall into one or more of the following five categories:

Distributions or withdrawals made to your estate or beneficiary after your death.
Distributions or withdrawals made because you became permanently disabled.
If your medical expenses exceed 7.5% of your adjusted gross income, then you may make a withdrawal up to the amount of your medical expenses in excess of the 7.5%.
Distributions made to the IRS to pay a levy on the plan itself.
Distributions or withdrawals made as part of a series of substantially equal periodic payments over the life expectancy of the owner and the beneficiary. If these withdrawals come from a plan other than an IRA (as is the case with a 401k plan), then you must separate from your employer before payments begin for this exception.

401k Withdrawal Exceptions

The following three exceptions also apply to 401k plans:

Distributions or withdrawals made to you after termination of employment, if the separation from your employer occurred in or after the calendar year you reached age 55.
Distributions of dividends from employee stock ownership plans.
Distributions or withdrawals made to an alternate payee under a qualified domestic relations order. (This often happens as part of a divorce settlement.)

401k Hardship Withdrawals

The exact rules followed by each 401k plan will vary, but generally you can attempt to make a 401k hardship withdrawal if you experience an immediate and heavy financial burden. To take a hardship withdrawal you must have no other financial means of meeting this hardship. Examples of financial hardship include:

Potential eviction / foreclosure on you principle residence.
You need substantially all of your current and anticipated income and assets to meet your current and anticipated ordinary and necessary living expenses.

You can't claim a hardship withdrawal if the repayment of money owed someone else merely causes a financial burden. That is, the burden of proof must be greater than merely the inconvenience of repaying a debt. You must really have no other way of paying back the money.

Tax Implications of 401k Withdrawals

Keep in mind that all of the above noted exceptions apply only to the 10% penalty tax. For example, money withdrawn from a 401k that meets one of the above exceptions is still subject to taxes such as federal income tax withholding. In fact, you may even have to make estimated tax payments to avoid withholding penalties.

We started this article by reminding you that the government established retirement plans such as 401k plans to provide for retirement income. However, the government realizes that under certain conditions, you may need to make a withdrawal before retirement occurs. Dipping into your retirement funds is a big decision and is worth discussing with a tax advisor, lender or financial consultant to see if a less expensive alternative exists.

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