The Internal Revenue Service made some IRA and 401k withdrawal rules as to when distribution can be taken from an IRA or a 401k plan. A 10-50% withdrawal tax penalty can be faced if these rules are not followed. The taxes depend on the type of account you are withdrawing from.
What are early 401k withdrawal rules?
Any 401k withdrawals that are taken before you attain the age of 59½ are termed early withdrawals and are taxed as ordinary income. An extra 10% penalty is also taxed on such withdrawals, although there are some exceptions.
Your money can be withdrawn penalty-free if you are:
- At least 55 years old and have lost your job.
- Permanently disabled or
- Under the terms of a qualified domestic relations order (QDRO) after you divorced.
The 401k money can also be used to pay for medical expenses that go beyond 7.5% of your modified adjusted gross income if your insurer does not cover them. This means that the payments came out of your own pocket.
When an early withdrawal is made, a good chunk of the savings is lost to taxes or penalties, the withdrawn amount also lost the growth that would have been made on it.
Although hardship distributions are allowed in some 401k, your employer must approve this in order to make it possible. The purpose of the distribution must be to meet an immediate significant need and should not exceed the amount necessary to meet the need.
How to borrow from 401k accounts?
If your employer allows it, borrowing from a 401k can be a better option than taking an early distribution. Although fees can apply, interest rates tend to be lower when compared to other types of loans and there is no credit check with this type of loan.
Interest must be paid, back to yourself, within 5 years or immediately you leave your job. The downside of taking this loan is that one of the main benefits of 401k will be lost, this is because after-tax money will be used to pay yourself back. Crucial months or years of earnings on that money could also be lost.
Another crucial downside is that, if for any reason you leave your job, the loan might have to be paid back within 90 days, and such loan balance is treated as a taxable income in that year. You can be pushed into a higher tax bracket by that, and be also hit with a 10% early withdrawal penalty.
What is a qualified distribution?
A qualified distribution is a withdrawal that can be made tax-free or penalty-free. The distributions can be taken under certain allowed circumstances or after you attain the age of 59½ years.
Although no penalties are imposed when you withdraw money after the age of 59½ years, income taxes are paid on the amount withdrawn if you have invested in a traditional IRA or a traditional pre-tax 401k with untaxed income. A tax deduction is taken at the time the contributions are made.
After retirement, it is best to start withdrawing money from tax-deferred accounts for which you have claimed tax deductions. Due to the fact that no income from working is earned at that time, you might be in a low tax bracket.
IRA early withdrawal rules
Income taxes and the 10% early withdrawal taxes are also imposed on early withdrawals from a traditional IRA account. As with the 401k, there are few exceptions, but there are also many differences.
If the money is intended to use for higher education expenses, first-time home purchases, or health insurance premiums that must be paid when you are not employed, then it can be withdrawn early.
A qualified domestic relations order (QDRO) is needed by Ira to divide the account after a divorce, but still, certain rules are imposed on them.
Roth IRA and Roth 401k Withdrawal rules
After-tax incomes are used to fund Roth accounts, so any withdrawals made from them is not treated as when you withdraw from regular IRA or 401k accounts. Provided that you are 59½ years or above and the account has been held for at least 5 years, the distributions are tax-free. Although if the account owner is disabled or died, the rules do not apply again.
But a 10% tax penalty is still levied on your earnings if you withdraw early from it. The originally contributed amounts can be withdrawn tax-free or penalty-free before you attain the age of 59½ because taxes have already been paid on that money.
What is the required minimum distribution?
When you attain the age of 72 years, you must start withdrawing the required minimum distributions from the traditional IRA accounts, otherwise, the IRS will charge you a tax to the tune of 50% of the money you should have withdrawn earlier.
Before the passage of the SECURE Act of 2019, the must-start age for taking early distribution was 70½ and it remained like that for those who attain the age of 70½ years before 1st January 2020 and 72 years for any other people who do not attain the age as of 1st January 2020.
Life expectancy tables are used by the IRS to decide how much can be taken out every year to avoid this 50% tax penalty. But as long as you are still in active service, your 401k can remain intact. Also, Roth Ira account owners don’t need to take the required minimum distributions at any time.