Penalties for Early Withdrawal from Your 401K

Everyone has hard times. Perhaps you or your spouse has suffered a life-threatening accident or illness that has stopped you from working and the mountain of medical bills has become unmanageable. Or maybe, like many Americans in today’s failing economy, you have been laid off from your job and are facing foreclosure on your home. You may be divorced and owe an alarming amount of money in alimony and child support. When it comes to your monetary woes, you may become desperate to find a way to pay for any number of unexpected financial hardships. And after all other options are exhausted, you will eventually turn your eyes to an account you have been investing in for years: your 401K. Strictly speaking, the 401K is a retirement account, one that is meant to be contributed to, but not drawn from, until the time it matures (when you reach the age of 59 ½). However, if you are willing to pay the piper, you can certainly use it as a virtual piggy bank beforehand. Just be prepared to face some hefty penalties if you choose to go this route.

For starters, there is income tax to be considered. Don’t think that you can get the money scot free just because you put it into the account before your income was taxed. So you’ll have to plan to withdraw sufficient funds to cover what you owe when April rolls around. In addition, there will be some serious penalties applied, namely the notorious 10% tax. If you do not qualify for any exemptions, but find that you need to withdraw funds anyway, be aware that 10% of anything you take will come right off the top and go to the government. Luckily, there are several exceptions to the rule (although most of them are not pleasant).

You may withdraw money from your 401K without additional taxation (aside from income tax) if you meet one of the following criteria: divorce (if distribution is ordered by a qualified domestic relations order, or QDRO), job loss (separation at age 55 or over), medical expenses (totaling more than 7.5% of your annual adjusted gross income), and death (in terms of disbursement of funds to beneficiaries). If you do not meet any of these qualifications for early withdrawal without penalty, there are still ways to get at the money and avoid further taxation.

If you are nearing retirement age and need some extra cash for reasons not acceptable for exemption, you may want to set up a substantially equal periodic payment plan (or SEPP). This type of disbursement will allow you to withdraw funds on an annual basis (by one of three methods of calculation), but it does come with some drawbacks. Once you begin to draw money, you can no longer contribute or distribute funds from your account or you will face immediate penalty.

Further, you must draw your annual “salary” from the 401K for at least five years or until you reach retirement age (59 ½), whichever comes last. That means if you start a SEPP account at the age of 57, you must continue to withdraw until the age of 62 (since five years comes after retirement age)