Along with individual retirement accounts (IRAs), 401K accounts are designed to provide people with the opportunity to save their money while taking advantage of tax benefits. Contributions to these accounts are tax deductible, allowing money to grow without being encumbered by tax reductions. These tax benefits are conferred by the government with the understanding that people like you will use them to save money for the future. A 401K is a retirement account, so if you want to take money out before retirement age, you will incur a penalty. This serves both as an incentive to keep money in these accounts and as a way for the government to recoup the tax benefits it provided in case you break your end of the agreement.
With these things in mind, how do you know what penalties you’ll have to pay? Your accountant will walk you through the process of taking money out of your 401K. In some cases, it may make sense to do so. If you find yourself in a tight spot, for instance, it may be advantageous to pull money out, even if you have to pay a penalty. You can’t make this decision until you know just how much it’s going to cost, however.
Understanding taxes and penalties
As with traditional IRA distributions, the magic age is 59 and a half years old. Once you reach this line of demarcation, you can withdraw retirement money without penalty. If you’re younger than that number, you’ll have to pay both taxes and a penalty. Money distributed through a 401K account will be taxed as ordinary income. In many instances, this is a positive for taxpayers. You’ll be in a lower tax bracket as you near retirement age, allowing you to pay less tax on this money. If you pull money out before the designated retirement age, however, you will owe a 10% tax on any distribution.
This is much easier to understand with an example. A 58-year old person pulling $50,000 from his 401K will owe tax on this as ordinary income. Assuming the money falls into the 25% marginal tax bracket, a person will owe $12,500 in tax on the distribution. Factoring in the 10% penalty, a person will have to pay $17,500 of their $50,000 in tax money alone. As you can see, an early distribution may chop your money nearly in half if you aren’t strategic about it.
Understanding exceptions to the rule
Not every distribution before retirement age incurs a penalty. There are some exceptions to this rule that are worth understanding. If you are at least 55 and your employment has been terminated, then your penalty is waived. Likewise, if you become disabled, you can access the money without penalty. Likewise, if you need to take the money out to satisfy a domestic order, then it incurs no penalty. Finally, if you happen to pass away and your money is given to an heir as a part of an estate, it incurs no penalty. While these exceptions are critical, you will incur a substantial penalty in most cases.