In truth, there is a 10% penalty on early withdrawal of 401k, the 10% early withdrawal fee is imposed by the IRS. In promoting long-term participation in retirement savings schemes that is sponsored by the employer, the tax is imposed on an early withdrawal.
Penalty on early withdrawal of 401k tips
- Withdrawal of funds is not allowed for participants in the traditional or the Roth 401k until they get to the age of 59½ years, the only exception is when they want to withdraw funds in order to cover various hardships or life events.
- A vesting schedule is offered by many companies which states the service’s number of years that is required for new employees to fully own the account.
- A 10% penalty on early withdrawal of 401k will be charged together with the income tax rate on the withdrawn amount when you withdraw before maturity.
- As a matter of fact, if retirement funds are withdrawn early, the money is treated as income.
Regulations of standard withdrawal
Normally, fund withdrawals on the traditional or Roth 401k plan by the participants are not allowed until they are 59½ or above, or they can’t work again maybe because of disability or illnesses. In such cases, the 10% penalty on early withdrawal of 401k is waived.
Major life events like home purchases, payment of tuition, or certain hardship distributions are the only exceptions to this rule. The rule also doesn’t apply to those who are age 55 years or above and separate from their employer or work in the public sector. Many participants of the 401k plans are bound by this rule.
How to calculate the basic penalty
Assuming your 401k through your current employer worth around $50,000. If, because of unforeseen circumstances, that money is suddenly needed, you can liquidate the whole account for no legal reasons. But an additional 10% penalty on early withdrawal of 401k, which is $5,000, is required to be paid by you at tax time. This will effectively reduce your withdrawal to $45,000.
The vesting schedule
The meaning of the term “vesting” is the right that an individual has in a 401k account. An employee is entitled to their account total balance when they are 100% vested. Although 401k contributions made by an employee are always 100% vested, the employer’s contribution may be subjected to a vesting schedule.
As discussed above, a vesting schedule is a 401k provision that is offered by many companies which states the number of years of services that is required for new employees to fully own the account and withdraw any employer’s contribution from the account.
The sponsoring employer dictates the specifics of the vesting schedule which is applicable to each 401k plan. Cliff vesting schedules are chosen by some companies in which an employee will be 0% vested for the first few years of service and will then be fully vested after the stipulated time.
Larger vesting percentages are progressively assigned by a graduated vesting schedule for each subsequent service year.
How to calculate the total penalty
Taking the above example for instance, if the 401k sponsored by your employer involves a 10% vesting schedule for each year of service after the first year, and you are able to work for just 4 full years, it means 30% of your employer’s contribution is what you are entitled to.
If funds are, however, removed from the account before you are age 59½, a 10% penalty on early withdrawal of 401k tax will be imposed on you in addition to the taxes you will owe the IRS.
If your 401k is made of equal parts employee and employer funds, it means you are entitled to just 30% of the $25,000 contributed by your employer, or $7,500.
It means if the full vested balance is to be withdrawn after 4 years, you are only entitled to withdraw $32,500. Deducting the IRS 10% ($3,250) charge from it, your withdrawal’s effective net value is reduced to $29,250. It means you only get $29, 250 from the plan.
The impact of income tax is another major factor to consider when you are making an early 401k withdrawal. Contributions are made to Roth 401k with after-tax money, so when withdrawing, no income tax is imposed. But, pre-tax money is used to make contributions to the traditional 401k, which means any funds withdrawn must be added in your gross income for that year when the distribution is taken.
Take for instance, if the 401k in the above example is a traditional account, and the income tax rate is 20% for the year you withdraw the funds. This means your withdrawal will be subjected to another 20% vesting reduction. The total impact of the tax will be 30% on your withdrawal which will be:
30% x $32,500 = $9,750.
This means you will only get $22,750 ($32,500 – $9.750) from the plan.
As seen in the example above, it is ideal to consider all these tax factors before attempting to make an early withdrawal from your 401k account. It, therefore, makes sense to understand what your total withdrawal will be after you calculate the penalty on early withdrawal of 401k and other taxes that will be imposed on you.