When considering a 401K withdrawal, proceed carefully. Every 401K withdrawal means sacrificing important benefits of a previous 401K plan contribution. Each 401K contribution is rewarded with tax benefits: not only is your contribution tax deductible, but also the investment growth of your account is tax-deferred.
401K Withdrawal Rules
With rare exceptions, all 401K withdrawals are taxable as ordinary income. An additional 10% early distribution penalty tax will be assessed if you have not reached at least age 59 ½ when you take your distribution. Several exceptions to this penalty include:
- You die and the account is paid to your beneficiary
- You become disabled
- You terminate employment and are at least 55 years old
- You withdraw an amount less than is allowable as a medical expense deduction
- You begin substantially equal periodic payments
- Your withdrawal is related to a qualified domestic relations order
Additional 401K Early Withdrawal Considerations
In addition to penalties and taxes due upon a 401K early withdrawal, you lose all the potential future investment growth of that retirement plan money. Furthermore, since there are annual limits to the amount you can contribute to a 401K plan, you can’t make up for a previous withdrawal later, even when you are on more solid financial ground.
Although 401K loans have their own significant drawbacks, consider a 401K loan if you are in a financial pinch and the only option appears to be your retirement money. A 401K loan should be preferable to an outright 401K withdrawal.
Delaying Your 401K Withdrawal
You may delay receiving distributions from your 401K plan and thereby maximize the benefits of your tax deferred growth until April 1 of the year following the year in which you reach 70 ½. (An exception is if you are still employed by a company you do not own 5% or more of.) Subsequently, you must withdraw at least your Required Minimum Distribution (RMD) annually.
Your RMD is calculated as your account balance as of the beginning of the year in question divided by your life expectancy as determined by the IRS in its Uniform Life Expectancy table (unless your sole beneficiary is your spouse and your spouse is more than ten years younger than you).
The penalty for not withdrawing your RMD is 50% of the difference between what should have been distributed and what was actually withdrawn.