Early Withdrawal Penalty from 401K Distribution

If you find yourself short on cash, you might be tempted to withdraw money from your 401(k), but it’s important to carefully consider if that’s the best option. When you make an early withdrawal, you’ll not only have less in your retirement fund, but you’ll also face an early withdrawal penalty. 

Thinking about tapping into your 401(k)? Already took funds and wondering how you’re going to pay for the penalty? To help you out, this post covers the basics. To get advice now, contact us at The W Tax Group today.

The Basics of Early Withdrawal Penalties

Your 401(k) is a retirement savings plan that allows you to contribute pre-tax money directly from your paycheck. Since there aren’t taxes on the money that you contribute to the 401(k), making contributions can help to reduce your annual tax liability while also helping you to save for retirement. 

But since your 401(k) is a tax-advantaged retirement fund, there are rules about when you can make withdrawals. If you make a withdrawal too early, you’ll pay a penalty and you’ll also pay taxes on the money you withdraw. Unfortunately, you generally cannot get abatement for 401(k) penalties. Ironically, if you have unpaid taxes, the IRS has the right to seize many of your assets, including your 401(k).

What Is an Early Withdrawal? 

Most withdrawals that you make before you are age 59 ½ years are considered to be early withdrawals. The IRS assesses a 10% early withdrawal penalty in addition to the income tax that you incur on the withdrawal. For example, if you withdraw $20,000, you will need to pay a $2,000 penalty on that money. 

Once you’re 59 ½ years old, you can make withdrawals without facing that extra early withdrawal penalty. However, the IRS makes a few exceptions for hardship situations that allow you to avoid the early withdrawal penalty. If you don’t qualify for a hardship situation, then the money you withdraw will be subjected to the standard 10% early withdrawal penalty. 

The Tax Implications of Early Withdrawals

In addition to your early withdrawal penalty, you will also be responsible for paying income taxes on the money you withdraw. In addition to federal income taxes, you may be responsible for state taxes. Your income tax rate will depend on whether you’re single or married, as well as the tax bracket that you fall into. Keep in mind that if you wait to make a withdrawal until you’re retired, your income will be lower and you may fall into a lower tax bracket, saving you money on taxes.

For example, as of 2023, if you’re married and filing joint returns and your income is between $89,450 and $190,750 per year, you will incur an income tax rate of 22% on your withdrawal and possibly more if your withdrawal causes your income to surpass this tax bracket. 

That means that you would pay $4,400 in federal income taxes on your $20,000 withdrawal. That’s in addition to the $2,000 early withdrawal penalty, so of your $20,000 withdrawal, you would only actually be left with $13,600 after paying your taxes and penalty. Any state tax liabilities would also reduce the amount of money that you take home. 

Exceptions to the Early Withdrawal Penalty

The IRS makes a few exemptions to the early withdrawal penalty. You may be able to withdraw money from your 401(k) without paying an early withdrawal penalty in several hardship situations:

• You are permanently disabled
• You are terminally ill
• You are at least age 55 and lose your job 
• You are paying qualifying college tuition, fees, and room and board for family member, like a spouse or dependent
• You are using the money to avoid foreclosure or eviction

Note that 401(k) withdrawals are also not subject to an early withdrawal penalty if you have passed away and the withdrawal is being made to your beneficiary or estate. However, there may be a variety of other tax implications in this situation.

There are many other specialized hardship situations, so if you’re considering making a 401(k) withdrawal, it’s a good idea to consult with a tax professional to identify any possible exemptions you might qualify for. 

The Notification and Payment Process

When you make an early withdrawal from your 401(k), the IRS requires the 401(k) service provider to withhold 20% of those funds for federal income tax. At the beginning of the next year, the plan administrator will send you a 1099-R with details of the distribution. It will show the amount withdrawn and taxes withheld. 

You will use that form when you complete your tax return. If the withholding exceeds your federal tax liability, then the IRS will return any money owed to you with your tax refund. However, if the penalty and withheld amount aren’t enough to cover your tax liability, you may end up owing a bill. 

Challenges in Paying the Penalty

If you withdrew money from your 401(k) without being aware of the penalty and tax implications, you might be surprised to see how little of that money you receive and how much you owe on your tax return. Plus, if you withdrew the money because you were already short on funds, then paying extra for taxes can be a serious financial strain. 

If you can’t pay your owed taxes in full immediately, then you should pay as much as you can by the tax due date. The IRS has several options for people who can’t pay their tax liabilities in full including the following:

1. Installment Agreement (Monthly Payments)

You can request an installment agreement from the IRS, which will allow you to pay off owed taxes in monthly payments over time. Arranging an installment agreement gives you more time to pay your taxes, and you’ll also have set payment due dates to help keep you on track. 

Taking the initiative to request an installment agreement can help you to reduce late payment penalties. When you set up a payment plan, the IRS will lower your failure-to-pay penalty from 0.5 or 1% per month to 0.25% per month.

2. Offer in Compromise

An offer is when the IRS lets you pay off your tax liability for less than you owe, but you have to prove that you cannot pay the bill. If you are in this financial state, you may even qualify for a hardship loophole that allows you to circumnavigate the early withdrawal penalty. 

3. Currently Not Collectible

If you convince the IRS that you don’t have any money to pay the bill, they may mark your account as currently not collectible and suspend collection actions against you.

4. Innocent Spouse Relief

This is a very specialized type of tax relief, but if you qualify, it can save you a lot of money. Innocent spouse relief comes into play in situations where your spouse incurred an early withdrawal penalty without your knowledge, and you want to separate yourself from their tax liability.

How to Avoid Early Withdrawal Penalties

Early withdrawal penalties deduct 10% of the money that you withdraw. When you pair those penalties with your tax responsibilities, your 401(k) withdrawal could be reduced by approximately 30% or even more. Plus, you’ll have less money left in your 401(k) to continue growing your retirement savings. 

Instead of tapping into your 401(k) early, consider other financial resources first. Borrowing money from family and friends, selling off some of your personal belongings, or taking on a part-time job can help you get the money you need to get through a financial pinch. In some cases, you may even be able to borrow money from your 401(k). Ask your plan administrator for details.

If you need a large amount of money quickly, there are some alternatives that may be a better decision than withdrawing funds from your 401(k). Check out the following:

• Personal loan: Consider applying for a personal loan from a bank or credit union. Depending on your credit score, you may need to secure the loan with an asset, like a vehicle. Securing your loan with collateral can also help you to qualify for a lower interest rate. 
• No-interest credit card: If you have a strong credit score, you may qualify for a zero-interest credit card. You can use the card to pay for your expenses, and you won’t face any interest as long as you pay off the balance within the offer period. Keep in mind that once that offer period, which can be a few months or years, ends, the interest rates will be steep, so you’ll want to pay off the full balance before the deadline. 
• Home equity loan: A home equity loan uses the equity in your home as collateral, which may help you to get a lower interest rate. You’ll receive your loan balance as a lump sum and will need to repay the loan based on the specified terms. If you can’t repay the loan in full, your lender could sell your home to pay off the remaining loan balance. 
• Home equity loan of credit: Like a home equity loan, a home equity line of credit uses your home’s equity as collateral. With a line of credit, you will be able to draw down your credit, pay it back, and then draw it down again during the line of credit term. This type of financing is popular for projects where you aren’t sure of the total amount of money you will need, such as if you’re renovating your home. 
• 401(k) loan: Rather than withdrawing money from your 401(k), you can borrow money and, as long as you pay it back within five years, you won’t face any penalties. You can borrow up to $50,000 or half of your 401(k) balance, whichever is lower. If you should leave your employer, you will have a short period to repay your entire loan, or you will face the same early withdrawal penalties and taxes that you would if you simply withdrew money. 

Rolling Your 401(k) Over to Another Qualified Retirement Plan

If you leave your job, you don’t have to empty your 401(k) and face an early withdrawal fee. Instead, you can choose to convert your 401(k) into an individual retirement account, or IRA. Alternatively, you may be able to roll the funds from one 401(k) to another 401(k).

Often, if you decide to cash out your 401(k), you can get the check, and then, as long as you deposit it in another account within 60 days, you don’t face a penalty. However, you can only do that once a year, and in certain cases (such as when you’re dealing with an inherited retirement account), you cannot do the transfer. Instead, you need to do a trustee-to-trustee transfer. 

If you are required to do a trustee-to-trustee transfer and you try to roll over the funds yourself, you risk incurring early withdrawal penalties and income tax. That’s why it’s critical to understand the rules before you take a withdrawal.

Get Help with 401(k) Penalties From The W Tax Group

If you’re already facing 401(k) early withdrawal penalties, you can still recover. Making a budget, creating a tax repayment plan, and focusing on paying down your tax debt can all help. 

It’s also important to work with a professional, who can guide you through the process and your options. The W Tax Group is an attorney-based tax resolution company that can help you with your 401(k) withdrawals and other tax concerns. We employ three IRS lawyers, and that team is led by Agustin Arbulu, a tax attorney and W Tax Group President and COO. We understand complicated tax codes and specialize in negotiating with the IRS or state to resolve and reduce your tax liabilities. To get help now, contact us today.

Whether you need help paying your early withdrawal penalties or are considering making a 401(k) withdrawal but aren’t sure if it’s the right move, let us help. Contact us today for a free consultation.