Retiring couple examining their 401k plans

401k Withdrawal Rules and Regulations

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A 401k is a company sponsored retirement plan, in which employees make pre-tax contributions into the investment vehicle of their choice (mutual funds, company stocks, money markets, etc). Typically, as an added incentive, an employer will match the contribution of the employee up to a fixed amount.

When can I withdraw from my 401k with no penalty?

A 401k plan is intended to be a retirement fund that encourages the individual to save for retirement, and qualified distributions can begin when an individual reaches 59.5 years old. The 401k withdrawal guidelines are pretty straightforward; if you have not reached the age of 59.5 years old, the IRS will assess a 10% penalty on early withdrawals. However, there are allowable distributions that are not subject to the early withdrawal penalty. These are:

  1. Distributions or withdrawals that are made to your estate after your death
  2. If you become permanently disabled
  3. IRS tax payments
  4. If you have medical expenses that exceed 7.5% of your income.

The IRS also does not assess an early withdrawal penalty if you are making a 401k withdrawal but are rolling it over to another retirement account. The reason the government does not impose a penalty is because the funds are going into a retirement plan for the purpose of saving for retirement. However, if you do not electronically transfer the 401k plan, you have 60 days in order to roll over the 401k account before that penalty will be assessed.

If you are under 59.5 and you would like to make a 401k withdrawal that is not considered a qualified distribution, you may be able to avoid the penalty if the 401k withdrawal qualifies under the IRS code of a safe harbor financial hardship. The tax code is very strict when it comes to what is considered a financial hardship and in order to determine if you qualify you should talk with a tax professional or financial advisor before proceeding.

How does an early 401k withdrawal affect my taxes?

Recall that 401k contributions are tax-deferred, meaning that individuals pay into their 401k with pre-tax earnings. Another added benefit of contributed to a 401k in terms of a tax benefit is that your contributions are tax deductible. As a result of this tax shelter, any withdrawal from your 401k account will be subject to federal withholding, meaning that you must pay taxes on the distribution because the IRS considers it income.

During tax season, if you are over the age of 59.5, any 401k withdrawal must be reported as income. If you decide to take an early withdrawal, your employer will withhold the federal taxes. The ordinary income tax rate is currently set at 20%. It is important to note that you may be able to defer paying federal taxes even longer if you are over the age of 70.5. The IRS stipulates that in order to be eligible, you have to meet certain criteria:

  1. You must still be employed
  2. You can not own 5% or more of the company you are working for.

If you satisfy those two items, you will not have to pay taxes on any 401k withdrawals until you actually retire. Be advised that you may still be required to take the required minimum distribution.

It is a big decision to make a 401k withdrawal, even if it is a qualified withdrawal. Aside from the tax withholdings that are required even if you are qualified to take a distribution, there could be penalties associated with a 401k early withdrawal and it is important to consider other alternatives if at all possible.

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