Calculating 401k Early Withdrawal Penalties

A 401k is probably the most well-known defined contribution plan on the market today. Over 50 million Americans have 401k plans, with close to $3 trillion in assets, and while that number has decreased, it is still pretty robust.

Probably the best benefit of a 401k is that it is through your employer; as a result, the employer can and often does contribute to your plan by matching your contributions – something an individual retirement arrangement (IRA) lacks. Throw in the tax advantages – your contributions are pre-tax, allowing you to grow your investment faster – and you have a nice way to save for retirement.

Of course, the big drawback is that you have to wait until you are 59 ½ in most cases to withdraw your money. This is to discourage people from taking advantage of the tax benefits of the system in their investments and withdrawing their money early. If you do – unless your withdrawal is covered under a hardship exception – you’ll owe penalties.

Sometimes, you just have to make an early withdrawal. Here, I’ll cover what you need to know about calculating 401k early withdrawal penalties so you can make an informed decision.

What the IRS Says About Early Withdrawal Penalties

The IRS is the government agency that deals with 401k plans and their tax implications – and as you can imagine, they have developed very strict rules and procedures for 401k contributions and withdrawals.

You can find their official policy here. Basically, the IRS frowns upon early withdrawals and assesses a 10% penalty (they call it a tax) on doing so. This 10% is calculated based off the size of the distribution. For example, if you are withdrawing $50,000, you would lose $5,000 right off the bat, leaving you with $45,000.

This 10% tax isn’t applied to every single early withdrawal, though. Any distribution that is tax-free does not count, so you won’t lose 10% on those. The most common example of this is when you rollover distributions to an IRA.

Also, if there are any excess deferrals or excess contributions, and they are returned to you, you will not be taxed on those either.

So, to calculate your 401k early withdrawal penalties, take the amount of your distribution and multiply by 0.10. That is the amount of money you will have to pay and report on Form 5329 to go with your income tax return for that year.

Are There Exceptions?

As with most things, there’s an exception to every rule. In this particular case, there are several. If you can prove to the IRS that a.) you need the money for emergency purposes; b.) can’t get it from any other source, like a loan; c.) have an immediate and severe financial burden; and d.) meet one of the exception criteria listed below, you have a case.

The IRS will more than likely waive the penalty if you fit one of these exceptions:

  • You die or become permanently disabled
  • You leave the job or are fired after the age of 55
  • You have to spend more than 7.5% of your adjusted gross income on qualified medical expenses
  • You have to disburse your money by court order for a divorce, separation, or custody agreement
  • You separated from your job and set up a plan to receive your distributions in equal installments over the course of your life

If you can prove that one of the above is true for you, then you can withdraw your money and avoid paying the hefty 10% fee.

Additionally, your employer may have penalties imposed on early withdrawals. The best place to look is in your 401k’s plan document, which should give you all the pertinent guidelines to how your 401k operates – and what penalties you would face if you withdrew early. This document is provided by your employer and is usually a good reference.

To recap:

  • If you withdraw your money before the age of 59 ½, you’ll be subject to a penalty on your distribution
  • This penalty is 10% of your distribution and must be reported on your taxes using Form 5329
  • There are hardship exemptions that allow you to avoid the penalty if you can prove a pressing financial hardship
  • Take a look at your 401k’s plan document supplied by your company for more information on penalties that could be assessed by your employer

Taking out a loan against the balance of your 401k account could be an alternative. You have to pay it back and pay interest, but you pay the interest to yourself and it just goes back into your 401k account, so most people try that option before withdrawing early.

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