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If you make an early withdrawal from a traditional 401(k) retirement plan, you must pay a 10% penalty on the withdrawal. There are some exceptions to this rule, such as certain health expenses and life events.
Learn more below about how to calculate your specific 401(k) early withdrawal penalty.
Key Takeaways
- Participants in a traditional 401(k) plan are not allowed to withdraw their funds until they reach age 59½, with the exception of withdrawing funds to cover some hardships or life events.
- If you withdraw funds early from a traditional 401(k), you will be charged a 10% penalty, and the money will be treated as income.
- Some 401(k)s follow a vesting schedule that stipulates the number of years of service required to own the employer contributions to the account, not just the employee contributions.
Withdrawal Regulations
Under normal circumstances, participants in a traditional 401(k) plan are not allowed to withdraw funds until they reach age 59½ or become permanently unable to work due to disability, without paying a 10% penalty on the amount distributed.
Exceptions to this rule include certain hardship distributions and major life events, like tuition payments or home purchases, and emergency expenses. There’s a variation of this rule for those who separate from their employers after age 55, but the majority of 401(k) participants are bound by this regulation.
Exceptions to the Penalty
Certain circumstances qualify for a penalty-free withdrawal. Yet even if these cases, you will still owe taxes on this money.
The following situations are examples of what the Internal Revenue Service (IRS) has deemed an “immediate and heavy financial need,” which is also called a hardship withdrawal. Such a withdrawal can be made to accommodate the needs of a spouse, dependent, or beneficiary. These include:
- Certain medical expenses
- Home-buying expenses for a principal residence
- Up to 12 months’ worth of tuition and fees
- Expenses to prevent being foreclosed on or evicted
- Burial or funeral expenses
- Certain expenses to repair losses to a principal residence (such as losses from fires, earthquakes, or floods)
In addition, a provision in the SECURE 2.0 Act allows you to to withdraw up to $1,000 a year for emergency personal or family expenses without paying the 10% early withdrawal penalty.
Important
You may not qualify for a hardship withdrawal if you hold other assets that could be drawn from, such as a bank account, brokerage account, or insurance policy.
Calculating the 401(k) Early Withdrawal Penalty
Let’s say you have a 401(k) plan worth $25,000 through your current employer. If you suddenly need that money, you can liquidate the whole account—but you’ll need to pay a penalty, unless you’re using the funds for certain covered reasons (see above). If your withdrawal doesn’t qualify, you must pay an additional $2,500—it’s a 10% penalty—at tax time. This effectively reduces your withdrawal to $22,500.
Vesting Schedules
Though the only penalty imposed by the IRS on early withdrawals is the additional 10% tax, you may still be required to forfeit a portion of your account balance if you withdraw too soon.
The term “vesting” refers to the degree of ownership that an investor has in an account. If an employee is 100% vested in their retirement account, it means they are entitled to the full balance of their account, which includes both employer and employee contributions.
It’s important to note that while employee contributions to a 401(k) are always 100% vested, contributions made by an employer may be subject to a vesting schedule.
A vesting schedule is a provision of a 401(k) that stipulates the number of service years required to attain full ownership of an account. Many employers use vesting schedules to encourage employee retention. This is because they mandate a certain number of years of service before employees are entitled to withdraw any funds contributed by the employer.
The specifics of the vesting schedule applicable to each 401(k) plan are dictated by the sponsoring employer. Some companies choose a cliff-vesting schedule in which employees are 0% vested for a few initial years of service, after which they become fully vested. A graduated vesting schedule assigns progressively larger vesting percentages for each subsequent year of service until the limit for full vesting is reached.
Calculating the Total Penalty
In the $25,000 example above, assume your employer-sponsored 401(k) includes a vesting schedule that assigns 10% vesting for each year of service after the first full year. This means if you worked for four full years, you are only entitled to 30% of your employer’s contributions.
If your 401(k) balance is composed of equal parts employee and employer funds, you are only entitled to 30% of the $12,500 that your employer contributed, or $3,750. This means that if you choose to withdraw the full vested balance of your 401(k) after four years of service, you are only eligible to withdraw $16,250. The IRS then takes its penalty, equal to 10% of $16,250 ($1,625), reducing the effective net value of your withdrawal to $14,625.
Tip
Once you reach a certain age—73 as of 2023—you’ll be subject to a 25% penalty if you don’t start taking required minimum distributions (RMDs) on the amount in your 401(k). Starting in 2024, a provision in the law eliminated RMDs for Roth 401(k)s, but not for traditional 401(k)s. One exception: If you’re still employed at 73 (or older), you don’t owe RMDs on the 401(k) at your current employer (unless you own 5% or more of the business).
Income Tax
Another factor to consider when making early withdrawals from a 401(k) is the impact of income tax. Contributions to a Roth 401(k) are made with after-tax money. No income tax is due on withdrawals. However, contributions to traditional 401(k) accounts are made with pre-tax dollars. This means that any withdrawn funds must be included in your gross income for the year when the distribution is taken.
Assume the 401(k) in the example above is a traditional account and your federal income tax rate for the year when you withdraw funds is 22%. In this case, your withdrawal is subject to the vesting reduction, income tax, and an additional 10% penalty tax. The total tax impact becomes 32% of $16,250, or $5,200.
How to Avoid 401(k) Early Withdrawal Penalties
To avoid having to make 401(k) withdrawals, you might consider taking a loan from your 401(k). This avoids the 10% penalty and taxes that would be charged on a withdrawal. Another possible option is to make sure your withdrawal meets one of the hardship withdrawal requirements.
Instead of tapping into your 401(k), you may also be able to use your individual retirement account (IRA) to avoid the withdrawal penalty. IRAs also charge a 10% penalty on early withdrawals, but they can be avoided if the withdrawal is used for one of the following:
- Unreimbursed medical expenses
- Health insurance premiums
- Permanent disability
- To fulfill an IRS levy
- You’re called to active military duty
Roth 401(k) Withdrawal Penalties
With a Roth 401(k), you can withdraw contributions and earnings penalty and tax free if you are at least 59½ years old and your account has been open for at least five years.
In general, if withdrawals don’t meet this criteria, they will be subject to the 10% penalty and taxes on your earnings. An exception is if you become disabled.
What Qualifies as a Hardship Withdrawal for a 401(k)?
Hardship withdrawals, which allow you to avoid the 10% penalty, can be taken for various reasons, including certain medical expenses, tuition, costs related to buying a primary residence or repairs, and funeral expenses.
What Is the Standard IRS Penalty for Withdrawing 401(k) Funds Early?
For early withdrawals that do not meet a qualified exemption, there is a 10% penalty. You will also have to pay income tax on those funds. Both calculations are based on the amount withdrawn.
How Old Do You Have to Be to Cash Out Your 401(k) Without Penalty?
For a normal withdrawal, you must be 59½ years of age or older.
The Bottom Line
It makes sense to consider all of your options before dipping into your 401(k). At the very least, understand what you will come away with after paying the early withdrawal penalty and the income taxes that you will owe.
