401(k) Withdrawal Rules: Early Withdrawal Penalty & Exceptions

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If you’re thinking of retiring — especially if you’re considering retiring early — it’s important to understand the 401(k) withdrawal rules and how to avoid paying a 401(k) early withdrawal penalty.

In this article, I’ll explain the age at which you can take penalty-free 401(k) withdrawals, the age at which the IRS requires you to withdraw from your 401(k) and some of the tax implications involved.

I’ll discuss Roth as well as traditional 401(k) plans, as there are some differences.


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401(k) Withdrawal Rules

The basic withdrawal rule for 401(k) plans is simple. If you withdraw from your 401(k) after you reach 59½ years of age, you won’t have to pay any penalties.

However, you will still owe income tax on funds in a traditional 401(k). If you contribute to a Roth 401(k) but receive a company match, that money goes into a traditional 401(k),so you’ll owe income tax on that money as well.

All that said, there are a number of exceptions that allow you to withdraw fund penalty-free before age 59½. Also, the longer you leave your 401(k) funds in your account, the more time you’re giving those funds to grow.


401(k) Early Withdrawal Penalty

Taking money out of your 401(k) early has consequences.

The IRS taxes early withdrawals (prior to 59½, unless you qualify for an exception) as ordinary income. You’ll also get hit with a 10% early withdrawal penalty on your taxes. Plus, you’ll lose the opportunity to make future earnings on your 401(k) investments.

Just to be clear, “getting taxed as ordinary income” means that in addition to the 10% penalty, you’ll have to pay federal income tax on the money you take out. You may also have to pay state income tax depending on where you live.

The 10% early withdrawal penalty is punitive. Tax-deferred (traditional) and tax-free (Roth) retirement accounts are designed to help fund your retirement, so the IRS wants to discourage you from using that money before you actually retire.

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The IRS also requires companies to withhold 20% of early withdrawals for taxes. So keep in mind that if you take out $10,000 before you’re 59½, you’ll receive only $8,000. Add the 10% tax penalty on the full amount you’re withdrawing and you can lop another $1,000 off that total when you do your next tax return.

If the 20% withholding is more than you owe according to your income tax bracket for the year, you’ll have to wait until your tax return for that year is processed to get your refund.

If you’re taking money out of a Roth 401(k), you’ll still pay a 10% penalty but only on your investment earnings — not on your contributions. (Remember, you contribute post-tax dollars to Roth retirement accounts, so the IRS already has gotten its cut.)

Also, with a Roth 401(k), you have to wait at least five years after you’ve opened your account before you can withdraw investment earnings without penalty. That’s the case even if you’re 59½ or older when you withdraw.


Required Minimum Distributions (RMDs) for 401(k) Plans

You don’t have to pay taxes on your traditional 401(k) contributions or earnings until you withdraw during retirement. But the IRS eventually gets a piece of that money.

That’s where Required Minimum Distributions, or RMDs, come into play.

You’re required to start taking money out of your 401(k) once you turn 72 years old. The amount you need to take out varies. But your first withdrawal is due by April 1 the year after you turn 72. And subsequent annual withdrawals are due by Dec. 31 each year.

If you delay taking your first RMD, keep in mind you may be making two withdrawals in the same year, which could impact your taxes.

If you don’t take out enough money, the penalty is steep. The IRS fines you 50% of the amount you should have taken out.

The IRS uses a life expectancy table to determine how much of your 401(k) account balance you must withdraw each year. Many 401(k) plan custodians will calculate your RMDs for you. But you can also calculate them yourself. If you have a spouse who’s a) your sole beneficiary and b) more than 10 years younger than you, use the Joint Life and Last Survivor Expectancy Table instead.

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You don’t have to take any RMDs from your 401(k) if you’re still working at 72 — at least not from your current employer’s plan. (You will have to take RMDs from any 401(k) accounts you have with former companies.) But if your current employer allows it and you’re still working, you can roll over the old 401(k) plans into your current plan before your 72nd birthday.

The IRS does allow you to take out the required amount from a single 401(k) or from a combination of 401(k) accounts.


Early Withdrawal Penalty Exceptions

Normally, you need to wait until you’re 59½ to withdraw from your 401(k) penalty-free. But there are exceptions.

Remember that taking early withdrawals is a quick way to deplete your retirement savings. It’s a good idea to talk to a financial advisor or a Certified Public Accountant (CPA) if you’re thinking about going that route.

The most common exception is probably the Rule of 55. If you leave your job for any reason during or after the year you turn 55, you’re allowed to make penalty-free withdrawals from your 401(k) plan at your most recent company. However, not all companies allow this.

There are other exceptions as well including a SEPP program (Substantially Equal Periodic Payments). SEPP programs allow you to take penalty-free withdrawals at any age, but you have to commit to withdrawing a significant amount of your 401(k) for five years or until you reach 59½, whichever comes later.

Other early withdrawal exceptions that apply to traditional and Roth 401(k) plans include:

  • Death
  • Total, permanent disability
  • Medical expenses that exceed 10% of your Modified Adjusted Gross Income (MAGI).
  • IRS levies
  • Qualified disasters
  • Military reservists who are called to active duty for at least 180 days

If you have less than $5,000 in your 401(k) account and you leave your job, it can trigger an automatic lump-sum distribution. At that amount, your company gets to decide whether it will allow you to keep your 401(k) plan with them.

In that situation, you can avoid a 10% early withdrawal penalty by rolling the money into an IRA.


Borrowing From Your 401(k)

Money expert Clark Howard strongly advises building an emergency fund so you have easily accessible money to pay for unexpected expenses. You want to rely on your emergency fund rather than tapping your retirement account if possible.

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But if your 401(k) plan allows it, borrowing from your 401(k) can be better than making early withdrawals.

The good news: Borrowing from your 401(k) doesn’t require a credit check. Interest rates on these loans can be competitive.

The bad news: You may get charged fees. You’ll have to pay yourself back with interest within five years — or within 90 days if you leave your job for any reason.

If you fail to pay back a 401(k) loan on time, the IRS will tax your unpaid balance as income. You may also incur that pesky 10% early withdrawal penalty.


Tax Strategies for 401(k) Withdrawals

Especially if you’re taking money from your retirement accounts before you’re 59½, there will be tax consequences. And with traditional 401(k) plans, you’ll owe taxes no matter how old you are when you take the money out.

Consult with a financial advisor or tax professional regarding your specific situation. But here are some potential ways to lower your tax burden.

  • Defer Social Security benefits. You’re allowed to start taking Social Security at 62 years old. But Clark recommends waiting as long as you can. Delaying your Social Security payouts is a way to reduce your tax burden while you’re taking 401(k) withdrawals.
  • Do your own tax-loss harvesting. You can sell losing investments to offset the income the 401(k) withdrawals will generate. (Note that the investments you sell at a loss must be in taxable brokerage accounts rather than retirement accounts.)
  • Intentionally halt withdrawals before jumping to a higher tax bracket. Be careful not to take out enough money to push you into a higher tax bracket if you can avoid it. Monitor your income and take 401(k) distributions up to the upper limit of your tax bracket.

Final Thoughts

For most people, withdrawing before you’re 59½ comes with a fairly harsh tax penalty.

Strongly consider leaving your 401(k) money alone well past 59½. It’s a significant piece of the retirement financial puzzle.

Even if you leave your job and stop contributing, allowing your 401(k) funds to grow tax-deferred for a longer time period will probably help you.

In general, 401(k) distributions are complicated, especially when it comes to taxes. So it’s smart to work with a financial advisor or a CPA who specializes in taxes.

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