401k Withdrawal Penalty

Knowing the 401k withdrawal rules can make a substantial difference in the funds available for one's retirement years. A single unwise decision can cost tens of thousands in future earnings. If a person is unaware of 401k early withdrawal penalty regulations, he or she is definitely at a disadvantage. Interested? Then perhaps it is time to take a look at this retirement plan.

The 401k is a retirement plan sponsored by the employer and governed by rules under section 401(k) of the International Revenue Code. The purpose of the plan is to allow workers to save for retirement and defer income taxes on this money and its earnings until the employee withdraws it at retirement time. With the employee's permission, a portion of the paycheck is paid directly into the account. Most of these plans are participant-directed, in that the worker can choose to utilize a number of investment opportunities: mutual funds generally made up of stocks, bonds, and money markets. Many companies also offer the option of investing in the company's stock. Employees are generally able to allocate funds as they see fit and reallocate if such a move seems prudent. Other plans are directed by trustees appointed by the employer. These trustees make decisions as to how the monies are to be invested.

All contributions used to be on a pre-tax basis. No tax would be imposed in the year the funds were dedicated. In 2006, the Roth provisions allowed that some or all of the contributions may be allocated to a separate Roth 401k. Under these provisions, distributions from the Roth plan would be tax free, and contributions would be on an after-tax basis. In other words, income tax would be paid on the contributions in the year they are given. Some companies match employee contributions, or make profit-sharing contributions to the accounts. In some cases, employers may choose to give a certain percentage of the employee's wages. Such benefits may have strings attached in that the contributions become viable after a certain number of years with the company. When an employee leaves the company, the 401k can stay active (though usually the employee cannot make further contributions and may have to pay maintenance fees) or be rolled over into an IRA or another plan at a new place of employment. The compounding interest without taxation on earnings is an attractive benefit of the plan, especially over a long period of time.

What about 401k withdrawal rules? Unlike the Roth IRA, the 401k accounts must begin to be distributed beginning April 1 of the year the employee turns 70.5. Those who are still employed at this age may receive a deferment. However, if the funds are not dispersed, either in a lump sum or according to a systematic plan, the tax penalties are severe. As to a 401k early withdrawal penalty, nearly all employers penalize an employee for withdrawing funds while one is still working there and is under the age of 59.5. Even withdrawals permitted before 59.5 are subject to a 10% tax, except for deductions to employees for certain medical expenses.

The IRS Tax Code does allow for hardship withdrawals under certain conditions. These include using funds for a down payment on a primary home, or to avoid foreclosure and eviction. Educational expenses for the employee, or spouse, dependents, or beneficiaries, and home repairs due to a deductible casualty loss are permitted, as are funeral expenses for parents, spouse, and dependents. Medical expenses which would normally be deductible on a federal income tax return (essential, not cosmetic services) are acceptable if they are not covered by insurance. However, the employer is not bound to include these provisions in the company's 401k withdrawal rules. Most companies do include at least some of these provisions, but check to be sure that this is an option in the present case. Also a 401k early withdrawal penalty which is often overlooked is that any amounts withdrawn are subject to taxation as regular income, and once the funds are taken, there is no provision for 'catching up' or repaying this money back into the account. This can result in significant loss as far as future retirement conditions. The loss comes from the fact that these funds would have compounded over the years and resulted in more money being available for retirement.

A more plausible solution for times in which such monies are the last resort in a difficult situation is to inquire about the possibility of obtaining a 401k loan. Such loans are not subject to taxes and penalties. Usually, one can continue to contribute to the account during the time while the loan is being repaid. This is not the case under certain withdrawals for hardship, where a 6 month waiting period may be imposed. If an employee leaves the job before paying the loan, the balance must be repaid or it will be treated as a withdrawal and subject to taxes and penalties.

The 401k retirement plan is exactly that -- a plan to help accumulate retirement money. Yet that can seem to be an elusive goal at times. Remember that A little that a righteous man hath is better than the riches of many wicked. (Psalm 37:16) A retirement plan can be a useful tool, but care must be taken to investigate the details offered under one's particular account. The 401k early withdrawal penalty is substantial. Therefore, it should be seen as a last resort when seeking emergency funds. In this way, an employee will not see his or her retirement dreams go up in smoke as a result of 401k withdrawal rules. Then the 401k will be able to function in the purpose for which it was designed.