Early Withdrawals from Traditional 401ks….What You Should Know. - A Business Blog Article from KLR

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Early Withdrawals from Traditional 401ks….What You Should Know.

posted Jun 1, 2018 by Peri Ann Aptaker, Esq., CPA/PFS, CFP® in the Business Blog

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Is your traditional 401k retirement account growing in value? It might be tempting to get your hands on those hard earned savings….but you need to be careful. Every 401k withdrawal means sacrificing important benefits down the road…not to mention a possible penalty tax. Read on.

First things first…what are the basics of a 401k?

Traditional 401k plans are qualified retirement plans sponsored by employers. Traditional 401k’s allow workers to save and invest part of their paychecks before taxes are taken out. Employees decide how much they want deducted from each paycheck and deposited into the 401k plan. Many times employers will “match” your contribution as an incentive for you to contribute.

Why do many consider early 401k withdrawals?

When an immediate need for cash arises, it is easy to consider an early 401k withdrawal…it’s your money after all, right? Whether you need a down payment for a new house, help with college tuition for your kids, or even help with an unexpected financial emergency, withdrawing early might cross your mind.

But….take this with a grain of salt. It’s crucial to proceed very carefully when considering an early withdrawal.

Early withdrawals

When you take money out of your traditional 401k early (“early” means any time before you reach age 59 ½), you will likely have to pay a penalty for doing so on top of paying income taxes on the withdrawal. Most often, the penalty you’ll pay to the IRS is 10% of what you withdraw (known as the “early distribution penalty tax”).

Picture this….

Let’s say that you are in the 25% tax bracket and decide to withdraw $10,000 from your traditional 401k. You will end up owing $2,500 in federal taxes, and $1,000 in IRS penalties (plus possibly state taxes). So…your $10,000 will cost you $3,500….worth it?

What are the exceptions to the withdrawal rules?

Withdrawals made before age 59 ½ are not subject to the early distribution penalty if the account holder:

  • Dies and the account is paid to his/her beneficiary
  • Becomes disabled
  • Terminates employment and is at least 55
  • Withdraws an amount less than is allowable as a medical expense deduction
  • Begins substantially equal periodic payments
  • Withdraws due to a qualified domestic relations order

Did the Tax Cuts and Jobs Act impact the withdrawal penalty rule?

Under the new tax law, there is a new exception for early withdrawals….a withdrawal due to a 2016 natural disaster will not be subject to the 10% early withdrawal penalty.

Wondering if you should withdraw before turning 59 ½? We can help you navigate the rules and come to the most cost-effective solution. Contact us today.