How to Calculate Early Withdrawal Penalties on a 401(k) Account

The IRS charges a 10% penalty on early 401(k) withdrawals

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. Learn more about how to calculate your specific penalty for early withdrawal below.

Key Takeaways

  • Participants in a traditional or Roth 401(k) plan are not allowed to withdraw their funds until they reach age 59½, with the exception of withdrawing funds to cover some hardships or life events.
  • Many companies offer a vesting schedule that stipulates the number of years of service required to fully own the account for new employees.
  • If you withdraw funds early from a 401(k), you will be charged a 10% penalty.
  • You will also need to pay an income tax rate on the amount you withdraw, since pre-tax dollars were used to fund the account.
  • In short, if you withdraw retirement funds early, the money will be treated as income.

Standard Withdrawal Regulations

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, without paying a 10% penalty on the amount distributed

Exceptions to this rule include certain hardship distributions and major life events, like tuition payments or home purchases. There are also 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.

Calculating the Basic Penalty

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 (10%) at tax time for the privilege of early access. This effectively reduces your withdrawal to $22,500.

There are certain exemptions that you can use to take a penalty-free withdrawal; however, you will still owe taxes on that money. These are for “immediate and heavy financial needs” that constitute a hardship withdrawal. Such a withdrawal can also be made to accommodate the need of a spouse, dependent, or beneficiary. These include:

  • Certain medical expenses
  • Home-buying expenses for a principal residence
  • Up to 12 months’ worth of tuition and fees
  • Expenses to prevent being foreclosed on or evicted
  • Burial or funeral expenses
  • Certain expenses to repair casualty losses to a principal residence (such as losses from fires, earthquakes, or floods

You likely will not qualify for a hardship withdrawal if you hold other assets that could be drawn from, such as a bank account, brokerage account, or insurance policy, in order to meet your pressing needs.

Vesting Schedules

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 they are entitled to the full balance of their 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.

Calculating the Total Penalty

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.

If you remove funds from your 401(k) before you turn age 59 1⁄2 , you will get hit with a penalty tax of 10% on top of the taxes you will owe to the IRS.

Income Tax

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.

Avoiding 401(k) Withdrawal Penalties

To avoid having to make 401(k) withdrawals, investors should consider taking a loan from their 401(k). This avoids the 10% penalty and taxes that would be charged on a withdrawal. Another possible option is make sure your withdrawal meets one of the hardship withdrawal requirements.

Note that if you have a Roth 401(k) you can withdrawal contributions tax-free. Instead of tapping into your 401(k), you may also be able to use your individual retirement account (IRA) to avoid the withdrawal penalty. IRAs also charge a 10% penalty on early withdrawals, but they can be avoided if the withdrawal is used for one of the following:

  • Unreimbursed medical expenses
  • Health insurance premiums
  • Permanent disability
  • To fulfil an IRS levy
  • You're called to active duty

What Qualifies as a Hardship Withdrawal for 401(k)?

Hardship withdrawals, which avoid the 10% penalty, can be taken for various reasons—such as certain medical expenses, tuition, costs related to buying a primary residence or repairs, and funeral expenses,

What Is the Standard IRS Penalty for Withdrawing 401(k) Funds Early?

For early withdrawals that do not meet a qualified exemption, there is a 10% penalty. You will also have to pay income tax on those dollars. Both calculations are based on the amount withdrawn. So if you are in the 20% tax bracket and take out $10,000 you will owe $1,000 in penalties and another $2,000 in income tax ($3,000 total due, leaving $7,000).

How Old Do You Have to Be to Cash Out Your 401(k) Without Penalty?

For a normal withdrawal, you must be 59 1⁄2 years of age or older.

The Bottom Line

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.

Article Sources
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  1. Internal Revenue Service. "Early Withdrawals from Retirement Plans."

  2. Internal Revenue Service. "Topic No. 558 Additional Tax on Early Distributions from Retirement Plans Other than IRAs."

  3. Internal Revenue Service. "401(k) Resource Guide - Plan Participants - General Distribution Rules."

  4. Internal Revenue Service. "Retirement Plans FAQs Regarding Hardship Distributions."

  5. Internal Revenue Service. "Retirement Topics - Exceptions to Tax on Early Distributions."

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