A 401k is a tax deferred retirement savings account which allows an individual to save for retirement on a pre-tax basis. Not only are the contributions tax free, but as the account balance grows, the interest income is also tax free. The 401k balance is not taxed until the owner of the account begins to withdraw funds, which in theory will be in retirement when the owner’s tax level is much less. Most 401k plans are employer sponsored and to further encourage their employees to save for retirement, many employers offer their employees a 401k match. This match is normally between 2% and 5% of the employee’s income.
Technically, someone can begin withdrawing from their 401k at any age. However, since 401k plans come with significant tax benefits and are designed to help save for retirement, early withdrawal, which is any withdrawal prior to being 59 and a half years old, often comes with a severe penalty.
One significant penalty is imposed by the employer who provides the 401k benefit to their employees. To discourage their employees from withdrawing funds early many employers charge a 10% fee for all premature withdrawals. However, many employers allow hardship withdrawals that are penalty free. Examples of hardship withdrawals include death of the employee, excessive medical expenses, or temporary or permanent disability.
While they do not want their employees withdrawing from their 401k, many employers do provide their employees with the option to take out a loan against their 401k without penalty. The loan can be used for just about anything, but is often capped at a certain dollar amount or 50% of someone’s vested balance. This loan normally comes with a low interest rate and requires repayment over a few years. If the loan is not repaid, then the employer will charge the 10% fee.
Another penalty of withdrawing from a 401k prior to turning 59 and a half years old are income taxes. When someone withdraws funds from their 401k, they will have to pay taxes on the amount they withdraw. The withdrawal will be taxed at the same levels as someone’s highest marginal tax bracket. For most people, withdrawing funds earlier than 59 and a half is disadvantageous because their tax bracket is bound to decrease after entering retirement. In most situations, when a 401k withdrawal takes place, the 401k servicer will hold back a certain portion of the funds which will be paid to the IRS when the account owner files their taxes.
Once a person reaches 59 and a half years of age, they can begin to withdraw from their 401k penalty free. However, it is highly advised that 401k distributions not be taken until the account owner has stopped working and their tax level decreases.
Once an individual reaches 70 and a half years of age, they are required to start making minimal distributions from their 401k. The minimum distribution is different for every individual and is based on current life expectancy tables that are held by the IRS. If the 401k account owner fails to withdraw the required amount, the IRS will charge a very high fee of 50% of the required distribution. However, the required distribution law does not apply to individuals who are still working.
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