If you really need to withdraw some money from your 401k plan, you should think twice before doing it. Why? Attention, attention. There is fire on the roof!
A 401k hardship withdrawal will cost you money. If you are going to take money out from your 401k plan prior to age 59 1/2 you are subject to a 10% Federal Tax Penalty.
That’s a real bummer. And that bummer has a name: It’s the so called 401k penalty, that can hit you really hard.
If you left your employer in or after the year in which you turned 55, you may not be subject to the 10% early withdrawal penalty. Be careful, because the so called Age 55 Rule also requires your separation from service.
If you don’t fulfill that requirement, you are also subject to the penalty, even if you are older than 55. See below an AGE 55 RULE EXAMPLE.
401(k) Early Withdrawal Costs Calculator
The example below is based on a simple calculation and reflects a generic 401k hardship.
|Penalty or Tax||Amount|
|Total amount you withdraw:||$50,000|
|Early Withdrawal Penalty|
(10% of withdrawal amount)
|estimated required Federal tax withholding (35%)||$10,000|
|estimated additional federal taxes you will owe||$7,500|
|estimated State tax you will owe (11%)||$5,500|
|TOTAL YOU PAY:||$28,000|
What are the 401(k) Penalties
the 401k Withdrawal Penalty just hurts
Looking at the tax regulation, the government doesn’t really give you any benefits when using any of the both 401(k) plans. What? What’s that suppose to mean? I thought the 401(k) plan is also supported by our government? I do not even get any tax benefits when selecting the traditional 401(k) contribution plan?
Please have a closer look at my 401k infographic. Take your time, and look at it very careful. When you do that, you’ll notice that you’ll have to pay always taxes on your contributions. No matter if you pay your taxes at the time of your contribution (401k Roth) or if you’ll be taxed when you’ll retire (401k Traditional).
The so called Internal Revenue Service, also known as the IRS will collect the taxes, no matter what.
It’s a pity, that most of the time people are being told (sold), that you should invest in a 401(k) plan because of the fact, that you can deduct your contributions from your annual income. Therefore, you’ll pay fewer taxes and it will benefit you.
ATTENTION: This is a bit of a twisted angle, how the 401k contribution is going to be sold to the masses.
Again, just as a friendly reminder. The IRS always collects the taxes from you. That means, you’ll always have to pay your income taxes on your 401k contributions. With the two given options (Roth+Traditional), you just decide when you are going to pay. Now, or in future?
So please always keep in mind: The one and only advantage you have participating in one of the two available 401(k) plans (the Traditional or the Roth) is the additional contribution of your employer.
And also remember, if you are investing your money into a 401(k) plan, your money will be locked until the age of 59 1/2 and is also tight to the Rule called “Separation from Service”.
The 401(k) early distribution punishment is a 10% Penalty!
Now you know for sure. The government created a rule, that will punish you if you take any money out from your 401(k) savings before the age of 59 1/2. And that’s a real bummer.
For every Dollar you’ll take out from your 401(k) funds before the age of 59 1/2 you’ll pay a 10% penalty. And on top of it, of course, you’ll have to pay for the Traditional 401(k) funds federal tax and your state income tax.
Age 55 Rule & The Catch
There is a little backdoor, to avoid paying a 10% penalty when withdrawing funds from your 401(k) plan. But that backdoor only works for people who are 55 years of age or older combined with a so-called “separation from service”.
First of all, this option is not really to consider for younger people. However, even when referring to the so-called Age 55 Rule, you need to be very careful. It requires two components, in order to use that rule.
- 55 years of age or older
- Separation from Service
To be very clear and specific about the meaning of the Age 55 rule. Distributions from your company plan are not subject to the 10% early distribution penalty if you are 55 years of age or older, and if you no longer work for the employer that made those contributions for you (or what the tax code refers to as “separation from service”).
What matters is the year you separate from the service (you quit your job, you got laid off, you got fired, or switched to another company, etc.)
Let’s have a closer look, how to understand the Separation from Service rule. Let me try to give you a simplified example.
Charly took a distribution, after he turned age 55. But still, the age 55 rule didn’t apply. He still had to pay his 10% penalty. Why the heck was that even possible?
He simple disqualified from being eligible for the AGE 55 EXCEPTION to the 10% penalty, because the day he left his employer [who was contributing to his funds at that particular time] was just at his age of 52.
That means, the so called Separation of Service happened clearly at the age of 52, and therefore he was NOT eligible for the exception of the AGE 55 RULE.
Boom. What a bummer. This really sucks. And yes, it sucks a lot.
That being said. Don’t just believe you can avoid a 10% penalty fee, because you’ll reached the age 55 or older and you are fine not getting a 10% Penalty for an early distribution.
It’s the year you separate from service that matters, but not the distribution date itself. To qualify for the penalty exception, separation from service must occur in the year you’ll turn age 55 or older.
And also, please don’t forget that we have been just talking about an exception for the 10% penalty. Of course, if the contributions have been made to a Traditional 401(k) plan, all the funds would still be subject to federal income taxes.
Wow. Now we figured, that’s a huge pile of crap you have been digging through very careful, right? So are we done yet, or is there even more on top of it?
Well, well, well… as we all know.. a pie has always some cream on top of it, right? And so it is with the 401(k) plan and its early distributions and the so-called AGE 55 Rule.
Can it be even worse? Can there be even more limitations? You’ll be surprised… yes it can!
Now let’s fasten your seat belt, because now we are just entering the heavy tornado season.
401k Withdrawal Rules
How to withdraw from 401k without losing money?
If you are 55 years old or older in the year you left your job (remember your age at the separation of service matters) and you need to take a distribution of your retirement plan funds immediately, you should leave the money in your company plan and take your withdrawals from there.
I repeat. You’ll have to leave the money in your company plan, and directly withdraw it from there. Why? Well, let me give you the reason why.
The reason why you need to withdraw it directly from your company plan: The age 55 exception does not apply to IRA distributions.
If you roll over company retirement plan money to an Individual Retirement Account, also known as a so-called IRA, withdrawals before age 59 ½ are subject to the 10% early withdrawal penalty unless one of the other exceptions applies (such as disability).
So, if you meet the age 55 rule and need to spend some of your retirement money, don’t roll over the amount you need to an IRA. If you do, and then take a distribution from your IRA, you will be hit with the 10% penalty. Once you roll over company plan money to an IRA, the IRA rules kick in and you can’t go back and use the age 55 rule.
Wow.. what a wonderful crazy complex world, just perfectly made for the government. One wrong step, and you’ll lose your money to the IRA. It’s actually really very annoying to see how the rules have been setup.
Setup with pitfalls and regulations that most of the time just works beneficial for the government only. So much about the rumors that the government supports you with your retirement plan.
Conclusion: To entirely stay out of all that hassle, just try to avoid early distributions at all.
In my next chapter I am going to reveal much more about the 401k Taxes. Trust me, you want to read this.