Stay Out of the 401k Penalty Box

penalties for withdrawing from 401k

Just like in hockey, there can be penalties with your 401(k).

High sticking in the NHL will get you a minimum 2 minutes in the penalty box. Same rules apply for cross-checking. In more severe cases, the penalty can be doubled that.

The bright side to all that is after the penalty time expires, you are allowed back on the ice to play again. Hopefully, with no harm to the team.

In retirement planning, this is often not the case, especially when it comes to your 401k.

If you find yourself in a financial emergency, you might consider withdrawing money from your 401k.

It might seem logical to use your own money to help yourself out of a financial bind, but there are penalties and taxes to be paid on money withdrawn from a 401k before retirement age.

Before considering this option, it is wise to be familiar with the taxes and penalties that will be charged.

Penalties for Withdrawing From 401k

The government considers a 401k strictly for retirement funding. Therefore, they charge heavily for early withdrawal to discourage people from taking their money before the age of 59 ½. The government charges a 10% penalty on any money taken from the 401k early.

There are a few exceptions to withdrawing from your 401k penalty free, including withdrawals made after ending employment with a company if you are over age 55, withdrawals made by your beneficiary after your death, in a divorce settlement, because of a permanent disability, or in financial hardship situations due to medical debt.

A quick note on financial hardships: To qualify for a 401k hardship withdrawal is tough. Typically, your employer will make you jump through hoops to qualify. If you do qualify, you then have to wait a minimum 6 months before you can restart contributing to your 401k.

If you are well under 59 1/2 and none of the above exceptions apply to you, this would be considered a “major penalty” in hockey terms. In fact, if you are even considering it, you might as well sit in the penalty box and contemplate your actions.

Tax Penalties

When you invest in a 401k for retirement, that is tax free income that you invested. When you withdrawal the money, you are responsible for paying the taxes.

The federal government charges anywhere from 15% to 35% based on your income bracket. You can look at your previous years tax return to determine what your tax bracket is and how much you will be charged.

The state government in the state where you live also charges tax when you withdrawal from your 401k. Generally state tax rates are much lower then the federal taxes, typically around 5%.

Additional Tax Penalty

Money you withdrawal from a 401k is considered income for the year. Depending on how much you withdrawal, this could move you into a higher tax bracket. That means you will pay even more taxes on that money during the next income tax year.

Doing the Math

Imagine you need to borrow $10,000 from your 401k for your financial emergency. If you withdrawal $10,000 you will pay $1,000 for the early withdrawal penalty, assume a 20% federal tax rate which would amount to $2,000, and a 5% state rate which would be $500.

That amounts to $3500 in taxes and penalties. That means you are only ending up with $6,500. So if you really need $10,000, then you need to withdrawal about $16,000. Of course the taxes and penalties on that $16,000 are about $5600, $2000 more than withdrawing $10k.

Most of us wouldn’t take out a loan that charged 50% interest. Withdrawing from a 401k is essentially charging yourself that much interest on the loan. Another consideration is that anything you withdraw obviously reduces the amount that you will have for your retirement which is never a good idea.

Withdrawing money from your 401k early (and even borrowing from your 401k) should be a last resort.

Jeff Rose, CFP® loves Crossfit workouts, writes about personal financial planning and craves In-N-Out burger. You can find him at Good Financial Cents.



Last Edited: June 23, 2014 @ 10:32 am The content of ptmoney.com is for general information purposes only and does not constitute professional advice. Visitors to ptmoney.com should not act upon the content or information without first seeking appropriate professional advice. In accordance with the latest FTC guidelines, we declare that we have a financial relationship with every company mentioned on this site.

Comments

  1. Good reminders. I was just advising a friend today that “borrowing” against his 401k is a bad idea. You may think you need the money now, but it’s just not worth missing a re-payment and paying the penalties.