Simplified 401K Early Withdrawal Rules

401(k) plans are permitted by the federal government to enable withdrawals even before retirement. However, the requirements for such 401k early withdrawal are onerous as the intention is that these funds be used for retirement. Once you understand the restrictions and costs, you may decide that a 401(k) early withdrawal is not worth it.

The amount that is taken out of 401(k) plans is treated as earnings. Hence, it is taxable. What follows from these 401k early withdrawals (those withdrawals taken prior to age 59 1/2) is that the federal and state income tax slashes a good 25%-40% from your amount. What makes it worse is that the 401(k) withdrawal, being counted as income, adds to your income and that makes you liable for more tax (e.g. potentially subject to a higher tax bracket), making it an extremely bitter pill to swallow.

If you are less than 59½ years of age, you are liable for a penalty of 10% on the withdrawal. So adding the federal tax, the state income tax, and the penalty, an early 401(k) withdrawal of $20,000 gets reduced to only $10,000 or less, that can actually be utilized. In a few cases, you can be released from paying the 10% penalty on 401(k) early withdrawals.

Following are the conditions that help you avoid the 401(k) early withdrawal penalty:

The amount paid if a member of the plan expires or is disabled.
If your age is 55 or more and you have stopped working or are now retired.
The distribution will be received in your lifespan as a component of the payments that are identical in terms of principal amount (substantially equal periodic payments).
If the 401(k) early withdrawal exist as a part of your job through an organization plan, you need to part with your employer before you start getting your payments for this exemption.
Your medical payments were more than 7.5% of accumulated gross earnings.
A ruling for divorce or a contract of separation passed by the court also makes a person eligible for the early 401(k) withdrawals.

Keep in mind that you still have to fork over the income tax on the 401(k) early withdrawal even though the above exceptions remove the 10% fine.

Hardship Withdrawals

You can go for an early 401(k) withdrawal if you there is an urgent financial emergency. But if you are under the age of 59 ½, you cannot escape paying a 10% penalty on the early withdrawal even after fulfilling all the other criteria. In order to get a hardship withdrawal, there should be no other monetary avenues available to you to fulfill the requirement.

Examples of financial hardship include:

Potential eviction or foreclosure on your principal 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 to someone else merely causes a financial burden. This means that there should not be a mere hassle of paying back the debt but a severe monetary strain that validates the need for an early withdrawal. There should not be any other method with which you can pay your money back.

401k Early Withdrawal Tax Implications

You should not forget that the above exceptions are applicable only to the 10% penalty. The withdrawal money from the 401(k) is still liable for the federal income tax even if it falls under the category of any of the above exemptions. Indeed there is a chance you will be required to make estimated tax payments in order to stay away from penalties (i.e. you may have to send a tax payment to IRS in the calendar quarter you get the early 401k withdrawal and not wait until next April 15).