How do I Avoid 401k Penalties?

A 401K is an employer-sponsored retirement account. Typically, individuals with 401K plans make regular contributions to their accounts and save money to handle expenses during their retirement years. In some cases, however, it is necessary or desirable to withdraw money before reaching the normal retirement age. Unfortunately, withdrawing money early means you will usually face a 10-percent penalty for the withdrawal as well as income taxes on the amount you withdraw. If you want to avoid 401K penalties, you'll usually need to wait until you reach the minimum retirement age, take a loan instead of a withdrawal, or qualify for a no-penalty hardship withdrawal.

The best way to avoid 401K penalties is to wait until you reach 59 and one half years old to withdraw your money. While you may still face income taxes, the amount you have to pay may be less if you are no longer working. Additionally, withdrawing at this age means you can avoid early withdrawal penalties.

When you take money from a 401K plan, the amount is considered income, and you’ll usually have to pay income taxes on it. If you withdraw $20,000 US Dollars (USD) from your 401K, for example, and your tax rate is 15 percent, you’ll have to pay $3,000 USD in taxes. If you are withdrawing money before you reach retirement age, you may also face a 10-percent penalty. For example, if you withdraw $15,000 USD, you’ll typically have to pay $1,500 USD as an early withdrawal penalty in addition to income taxes.

If you need money from your 401K and cannot wait until retirement age, you may consider taking a 401K loan. With a 401K loan, you are essentially borrowing from yourself. This type of loan isn’t subject to a credit check and is usually easy to acquire. You will have to pay interest on this 401K loan, but the interest is usually paid into your 401K account. Taking a loan instead of a withdrawal allows you to avoid 401K penalties.

In some cases, you may also avoid 401K penalties by taking a hardship withdrawal from your 401K. For example, if you are permanently disabled or need money for medical expenses, you may escape the 10-percent penalty. You may also escape the penalty if a judge has ordered you to give the money to your spouse in a divorce proceeding. If you lose your job or retire when you are 55 or older, you may qualify for a no-penalty withdrawal as well. You may be subject to income taxes on the money, however.