How do I Avoid a 401k Withdrawal Penalty?

The 401k withdrawal penalty, which is 10 percent of any withdrawals from a 401k savings plan before the owner turns age 59-and-a-half, can be avoided if at least one of the following five conditions is met: the owner is disabled or dies before age 59-and-a-half, the withdrawal is made to meet excessive medical costs, the withdrawal is ordered as part of a divorce decree or separation agreement, the owner retires or is fired at age 55 or older, or “substantially equal” periodic withdrawals are paid out to the owner.

A 401k plan is an employer-sponsored savings plan in the United States, usually intended to be a component of an employee's retirement savings program. Funds are withheld on a pre-tax basis from individual workers' pay and contributed to their 401k accounts, subject to limitations imposed by the Internal Revenue Code (the Code). Some employers also match some or all of their employees' contributions. There are a wide variety of presumptively safe products in which to invest 401k accounts. Any growth, whether due to capital gains or interest income, is not taxed until the funds are withdrawn. When funds are withdrawn, or distributed, they are subject to taxation as ordinary income at the owner's then-applicable tax rate.

Since 401k plans were established to give taxpayers a tax-deferred way of saving for retirement, the 10 percent penalty on distributions before that age is intended to discourage taxpayers from drawing down their retirement savings for other purposes. However, in the case that the owner of the account meets one of the five circumstances defined by the Code before turning age 59-and-a-half, he or his beneficiary can receive distributions without incurring the penalty.

If the owner dies or becomes disabled before age 59-and-a-half, distributions can be made penalty-free, either to the disabled owner or the beneficiaries, as appropriate. Another exemption is for the payment of medical costs in excess of 7.5 percent of the owner's Adjusted Gross Income (AGI). In addition, when a couple divorces, 401k accounts are often a significant component of the marital assets, and a qualified domestic relations court order, essentially a divorce decree or a separation agreement, may order the distribution of some part of the account to the account owner's spouse. These distributions are exempt from the 401k withdrawal penalty.

The Code permits distributions before age 59-and-a-half for individuals who retired, quit, or were fired at age 55 or older, but only with respect to the 401k account sponsored by that final employer. Distributions taken from other 401k accounts are still subject to the early withdrawal penalty. This is a good reason to close out old 401k accounts and consolidate them.

A final way to avoid a 401k withdrawal penalty is called the “substantial equal payments” exception. Called a Section 72(t) exception, referring to that section of the Code authorizing them, it states that distributions can be made to the owner if they're based on the owner's life expectancy and the payments, are substantially equal. These payments must be made annually and continue until the later of five years or the owner's attainment of age 59-and-a-half.

Another 401k withdrawal penalty is sometimes overlooked because it's incurred only when the account owner actually fails to withdraw funds from the account. Generally, the Code requires that a required minimum distribution (RMD) be taken from any tax-qualified account, like a 401k or an IRA, every year, beginning before April 1 of the year following the year the account owner turns age 70-and-a-half. This penalty is severe — 50 of the amount that should have been withdrawn. Thus, those with RMD requirements to meet should carefully review their distributions to ensure they're taking at least the RMD amount.

Note that since all funds contributed to a 401k, as well as any earnings, were originally credited on a tax-deferred basis, income tax at regular rates is due on all distributions, and there's no way to avoid that requirement. It should also be kept in mind that rollovers of 401k funds into other tax-qualified retirement plans, where the funds are moved from one financial institution to another without actually coming into the owner's possession, are not considered distributions and thus aren't subject to the 401k withdrawal penalty.