A premature 401(k) withdrawal is a triple whammy.
First, the early 401(k) distribution is taxed as income. If you withdraw $10,000 and are in the 22% Federal tax bracket, you will incur $2,200 of Federal tax liability, reducing the net distribution after taxes to $7,800. And keep in mind that an early 401(k) withdrawal may push you into a higher tax bracket. It’s essential that you prepare an accurate projection of your expected tax liability before requesting a distribution.
Second, the IRS imposes a 10% penalty on early 401(k) distributions. Note that the 10% penalty is assessed on the amount distributed, not the net distribution received after taxes are withheld. In this example an additional $1,000 is owed (10% of $10,000) thus further reducing the distribution received from $7,800 to $6,800.
Unfortunately many people realize the compounded effect of taxes and penalty will be so onerous that they will need to increase the amount of their distribution to receive the desired cash. Requesting a larger early distribution only increases the amount of the tax and penalty. In addition, it further increases the likelihood of moving into a higher tax bracket.
As if losing 32% of your funds to taxes and penalty isn’t painful enough, it is important to quantify the expected loss in growth potential. Withdrawing $10,000 (to only receive $6,800 in our example above) will likely have a material impact on your long-term savings. Avoiding an early distribution allows the $10,000 the opportunity to appreciate over time. If you earn 5% over 20 years until retirement your 401(k) balance would be $26,533 higher thanks to avoiding the premature distribution.
Fortunately the IRS offers some exceptions to the 10% penalty. Consult a qualified tax advisor if you are disabled, subject to an IRS tax levy, facing significant medical expenses or called for active duty.
For those close to age 59 1/2 it may be advantageous to consider a lesser known strategy referred to as 72(t) or “substantially equal periodic payments (SEPP).” Again, consult with a qualified tax advisor to determine if entering into an arrangement to distribute funds over at least a five year time period may provide necessary cash while avoiding the 10% early withdrawal penalty.
It may be advantageous to consider a distribution from a Roth IRA instead of your 401(k). Many do not realize that contributions to a Roth IRA can be withdrawn without concern for tax or penalty. Note that earnings on those contributions are treated much differently.
The articles presented on this blog are general in nature and should not be assumed to be applicable to your situation. In addition, tax law changes daily and the articles on this blog are not updated to reflect these changes. Anyone receiving any part of the information on this blog should not rely on or act or refrain from acting on the basis of any matter or information contained in this blog without seeking appropriate tax, legal or other professional advice. The transmission and receipt of information contained on this blog does not form or constitute a client relationship. Nothing in this blog constitutes legal advice. Opinions rendered by tax professionals are not authority. You agree to hold Brendan Willmann, CFA, CFP®, CPA, EA, forever harmless from any liability for your use or failure to use the information, advice, referrals, or suggestions provided by this blog at any time.