The federal government allows qualified plans to have provisions for early withdrawals from 401k plans prior to retirement. But since this money is meant to be utilized for retirement, it's quite difficult to qualify for the early withdrawal process. There is a chance that you will give the decision a second thought when you weight the expenditure and the pre-conditions that are to be followed.
An early withdrawal from a 401(k) is treated by IRS as earned income and as such, you will pay federal, and if applicable, state income tax on it. What follows from these early withdrawals from 401k is that the income tax slashes a potentially 25%-40% off the top. Even worse, because the 401(k) early withdrawal increases your income, it may even push you into a higher tax bracket, thereby exacerbating the tax bite. The federal as well as the state income taxes are affected by this distribution. But taking an early withdrawal from your 401k gets a little worse.
In case you are less than 59½ years of age, you are liable to a penalty of 10% on the withdrawal. Now, with the federal and state income tax, plus the penalty it's possible that your $50,000 401k early withdrawal only nets you $25,000 to use.
It is possible to be excused from the penalty of 10% that accompanies the 401(k) premature withdrawals.
Exceptions from the early withdrawal from 401k penalty
- The amount paid if a member of the plan expires or is disabled.
- For people who are older than 55 years of age, have quit their employer, or have retired from their profession.
- You receive the distribution as part of "substantially equal payments" over your lifetime. If your company plan has made provisions for these 401(k) withdrawals, it's a prerequisite that you have to leave the company in order to start receiving your payments.
- In case your health expenses were above 7.5% of your adjusted gross income.
- The 401(k) hardship withdrawals are allowed for a legal order passed by a qualified domestic relations court for a declaration of divorce or separation.
Note that while the above five exemptions eliminate your need to pay the 10% penalty, you still need to pay the income tax on the early 401(k) withdrawal. You have to decide whether an early 401k withdrawal is really worth it.
Early withdrawal from 401(k) for Hardships
You can attempt to make a 401k hardship withdrawal if you experience an immediate and heavy financial burden. But if you are under the age of 59 ½, you cannot escape paying a 10% penalty on the early withdrawal even if are fulfilling all the other criteria. You can avail an early 401(k) withdrawal only if you have no other sources to meet the economic needs of your crisis.
Some examples of financial emergency are:
- If there is a possibility of expulsion from your primary residence. You are in need of all your considerable assets and estimated future earnings to cope with the demands of regular as well as basic necessities of life.
- You can't claim a hardship withdrawal if the repayment of money owed to someone else merely causes a financial burden. It indicates that the reason behind needing a withdrawal must be greater than just the trouble caused by a need to pay off arrears. You should not have any other means of repaying the money.
Implications of tax of 401k hardship withdrawals
Keep in mind that all of the above noted exceptions apply only to the 10% penalty tax. For instance, even if the withdrawal amount from the 401(K) meets even a single exclusion given above, it still comes under the federal income tax custody. Indeed there is a chance you will be required to deposit estimated tax payments in order to stay away from late tax payment penalties (see failure to pay estimated tax).
Lose a Fortune on Your 401k Rollover
If you do not do any of these correctly:
- Opt for a distribution rather than direct transfer
- Rollover company stock to an IRA
- Choose to rollover to a Roth IRA
- Rollover to your new employer’s 401k
- Rollover post-tax contributions