In this article, we're going to be discussing 401(k) withdrawals. This includes early withdrawals, and allowed distributions under current rules. We're also going to discuss potential tax penalties that may apply to early withdrawals.
Pension plans such as IRAs and 401(k) plans were put into place by the government to encourage families to save money towards retirement. It only makes sense the government discourages the use of these funds for purposes other than retirement. In fact, the tax law imposes an additional 10% penalty on certain early distributions from these funds.
An early withdrawal involves any money withdrawn from an account before reaching the age of 59 1/2. This particular withdrawal rule is not unique to 401(k) plans, but also applies to:
If the withdrawal is taxable, which is usually the case with a large proportion of the money in a 401(k) account, then not only does the accountholder have to report this as income on their federal income tax return, but they are also subject to an additional 10% penalty.
The Internal Revenue Service does not impose a penalty on withdrawals or distributions that are rolled over into another retirement plan. The investment is still serving its intended purpose: retirement income.
From the IRS's perspective, a 401(k) rollover occurs when an individual withdraws cash, or other assets, such as stocks, bonds, and mutual fund shares from one qualified employer's plan, and transfers it into another 401(k)plan, a qualified retirement plan, or a Traditional IRA within 60 days.
The IRS also allows for penalty-free withdrawals from a qualified retirement plan that falls into one or more of the following five categories:
The following three exceptions also apply to 401(k) plans:
The exact rules followed by each plan will vary, but generally a 401(k) hardship withdrawal is allowed if the accountholder experiences an immediate and heavy financial burden. To take a hardship withdrawal they must have no other financial means of meeting this hardship. Examples of financial hardship include:
A hardship withdrawal cannot be claimed if the repayment of money owed another party merely causes a financial burden. That is, the burden of proof must be greater than merely the inconvenience of repaying a debt. There must be no other way of paying back the money owed.
All of the above noted exceptions apply only to the 10% penalty tax. For example, money withdrawn from a 401(k) that meets one of the above exceptions is still subject to federal income tax withholding. In fact, it may be necessary to make estimated tax payments to avoid withholding penalties.
This article started off with a reminder that the government established retirement plans such as 401(k) plans to provide for retirement income. However, the government realizes that under certain conditions, individuals may need to make a withdrawal before retirement occurs. Dipping into a retirement fund 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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