Generally speaking, the only penalty assessed on early withdrawals from a 401(k) retirement plan is the 10% additional tax levied by the IRS. This tax is in place to encourage long-term participation in employer-sponsored retirement savings schemes.
Under normal circumstances, participants in a traditional or Roth 401(k) plan are not allowed to withdraw funds until they reach age 59½ or become permanently unable to work due to disability. Though there are some variations of this rule for those who separate from their employers after age 55 or work in the public sector, the majority of 401(k) participants are bound by this regulation.
Assume you have a 401(k) plan worth $25,000 through your current employer. If you suddenly need that money for an unforeseen expense, there is no legal reason you cannot simply liquidate the whole account. However, you are required to pay an additional $2,500 at tax time for the privilege of early access. This effectively reduces your withdrawal to $22,500.
Though the only penalty imposed by the IRS on early withdrawals is the additional 10% tax, you may still be required to forfeit a portion of your account balance if you withdraw too soon.
The term "vesting" refers to the degree of ownership an employee has in a 401(k) account. If an employee is 100% vested, it means he is entitled to the full balance of his account. While any contributions made by employees to a 401(k) are always 100% vested, contributions made by an employer may be subject to a vesting schedule.
A vesting schedule is a provision of a 401(k) that stipulates the number of service years required to attain full ownership of an account. Many employers use vesting schedules to encourage employee retention because they mandate a certain number of years of service before employees are entitled to withdraw any funds contributed by the employer.
The specifics of the vesting schedule applicable to each 401(k) plan are dictated by the sponsoring employer. Some companies choose a cliff vesting schedule in which employees are 0% vested for a few initial years of service, after which they become fully vested. A graduated vesting schedule assigns progressively larger vesting percentages for each subsequent year of service.
In the example above, assume your employer-sponsored 401(k) includes a vesting schedule that assigns 10% vesting for each year of service after the first full year. If you worked for just four full years, you are only entitled to 30% of your employer's contributions.
If your 401(k) balance is composed of equal parts employee and employer funds, you are only entitled to 30% of the $12,500 your employer contributed, or $3,750. This means if you choose to withdraw the full vested balance of your 401(k) after four years of service, you are only eligible to withdraw $16,250. The IRS then takes its cut, equal to 10% of $16,250 ($1,625), reducing the effective net value of your withdrawal to $14,625.
Another factor to consider when making early withdrawals from a 401(k) is the impact of income tax. Contributions to a Roth 401(k) are made with after-tax money, so no income tax is due when contributions are withdrawn. However, contributions to traditional 401(k) accounts are made with pretax dollars, meaning any withdrawn funds must be included in your gross income for the year the distribution is taken.
Assume the 401(k) in the example above is a traditional account and your income tax rate for the year you withdraw funds is 20%. In this case, your withdrawal is subject to the vesting reduction, income tax and the additional 10% penalty tax. The total tax impact become 30% of $16,250, or $4,875. This reduces your net withdrawal amount to $11,375, less than half of your original balance.
As you can see from the above example, it makes sense to consider all of your options before dipping into your 401(k). At the very least, understand what you will come away with after you calculate the early-withdrawal penalty and other taxes that you will owe.