How to Calculate Early Withdrawal Penalties on a 401(k) Account (2023)

Generally speaking, the only penalty assessed on early withdrawals from a traditional 401(k) retirement plan is the 10% additional tax levied by the Internal Revenue Service (IRS), though there are exceptions. This tax is in place to encourage long-term participation in employer-sponsored retirement savings schemes.

Learn more below about how to calculate your specific penalty for early withdrawal.

Key Takeaways

  • Participants in a traditional 401(k) plan are not allowed to withdraw their funds until they reach age 59½, with the exception of withdrawing funds to cover some hardships or life events.
  • Many companies offer a vesting schedule that stipulates the number of years of service required to fully own the account for new employees.
  • If you withdraw funds early from a traditional 401(k), you will be charged a 10% penalty.
  • You will also need to pay income tax on the amount you withdraw, since pretax dollars were used to fund the account.
  • In short, if you withdraw retirement funds early, the money will be treated as income.

Standard Withdrawal Regulations

Under normal circumstances, participants in a traditional 401(k) plan are not allowed to withdraw funds until they reach age 59½ or become permanently unable to work due to disability, without paying a 10% penalty on the amount distributed.

Exceptions to this rule include certain hardship distributions and major life events, like tuition payments or home purchases, and emergency expenses. There are also some variations of this rule for those who separate from their employers after age 55 or work in the public sector, but the majority of 401(k) participants are bound by this regulation.

Calculating the Basic Penalty

Assume you have a 401(k) plan worth $25,000 through your current employer. If you suddenly need that money for an unforeseen expense, there is no legal reason why you cannot simply liquidate the whole account. However, you are required to pay an additional $2,500 (10%) at tax time for the privilege of early access. This effectively reduces your withdrawal to $22,500.

There are certain exemptions that you can use to take a penalty-free withdrawal, but you will still owe taxes on that money. These are for an “immediate and heavy financial need” that constitutes a hardship withdrawal. Such a withdrawal can also be made to accommodate the need of a spouse, dependent, or beneficiary. These include:

  • Certain medical expenses
  • Home-buying expenses for a principal residence
  • Up to 12 months’ worth of tuition and fees
  • Expenses to prevent being foreclosed on or evicted
  • Burial or funeral expenses
  • Certain expenses to repair casualty losses to a principal residence (such as losses from fires, earthquakes, or floods)

In addition, starting in January 2024, a provision in the SECURE 2.0 Act of 2022 will allow you to to withdraw up to $1,000 a year for emergency personal or family expenses without paying the 10% early withdrawal penalty.

You likely will not qualify for a hardship withdrawal if you hold other assets that could be drawn from, such as a bank account, brokerage account, or insurance policy, to meet your pressing needs.

Vesting Schedules

Though the only penalty imposed by the IRS on early withdrawals is the additional 10% tax, you may still be required to forfeit a portion of your account balance if you withdraw too soon.

The term “vesting” refers to the degree of ownership that an employee has in a 401(k) account. If an employee is 100% vested, it means they are entitled to the full balance of their account. While any contributions made by employees to a 401(k) are always 100% vested, contributions made by an employer may be subject to a vesting schedule.

A vesting schedule is a provision of a 401(k) that stipulates the number of service years required to attain full ownership of an account. Many employers use vesting schedules to encourage employee retention. This is because they mandate a certain number of years of service before employees are entitled to withdraw any funds contributed by the employer.

The specifics of the vesting schedule applicable to each 401(k) plan are dictated by the sponsoring employer. Some companies choose a cliff-vesting schedule in which employees are 0% vested for a few initial years of service, after which they become fully vested. A graduated vesting schedule assigns progressively larger vesting percentages for each subsequent year of service until the limit for full vesting is reached.

Calculating the Total Penalty

In the $25,000 example above, assume your employer-sponsored 401(k) includes a vesting schedule that assigns 10% vesting for each year of service after the first full year. If you worked for just four full years, you are only entitled to 30% of your employer’s contributions.

If your 401(k) balance is composed of equal parts employee and employer funds, you are only entitled to 30% of the $12,500 that your employer contributed, or $3,750. This means if you choose to withdraw the full vested balance of your 401(k) after four years of service, you are only eligible to withdraw $16,250. The IRS then takes its cut, equal to 10% of $16,250($1,625), reducing the effective net value of your withdrawal to $14,625.

Once you reach a certain age—73 in 2023—you’ll be subject to a 25% penalty if you don’t start taking required minimum distributions (RMDs) on the amount in your 401(k). Before the passage of the SECURE 2.0 Act, the penalty was 50%. Starting in 2024, a provision in the law eliminates RMDs for Roth 401(k)s, but not traditional 401(k)s. One important exception: If you’re still employed at 73+, you don’t owe RMDs on the 401(k) at your current employer.

Income Tax

Another factor to consider when making early withdrawals from a 401(k) is the impact of income tax. Contributions to a Roth 401(k) are made with after-tax money. No income tax is due when contributions are withdrawn. However, contributions to traditional 401(k) accounts are made with pretax dollars. This means that any withdrawn funds must be included in your gross income for the year when the distribution is taken.

Assume the 401(k) in the example above is a traditional account and your income tax rate for the year when you withdraw funds is 22%. In this case, your withdrawal is subject to the vesting reduction, income tax, and additional 10% penalty tax. The total tax impact becomes 32% of $16,250, or $5,200.

Avoiding 401(k) Withdrawal Penalties

To avoid having to make 401(k) withdrawals, investors should consider taking a loan from their 401(k). This avoids the 10% penalty and taxes that would be charged on a withdrawal. Another possible option is to make sure your withdrawal meets one of the hardship withdrawal requirements.

Instead of tapping into your 401(k), you may also be able to use your individual retirement account (IRA) to avoid the withdrawal penalty. IRAs also charge a 10% penalty on early withdrawals, but they can be avoided if the withdrawal is used for one of the following:

  • Unreimbursed medical expenses
  • Health insurance premiums
  • Permanent disability
  • To fulfill an IRS levy
  • You’re called to active military duty

Roth 401(k) Withdrawal Penalties

Because contributions are made with after-tax dollars, if you have a Roth 401(k), you can withdraw contributions penalty free at any time. Earnings can be withdrawn without paying taxes and penalties if you are at least 59½ years old and your account has been open for at least five years.

In general, if withdrawals don’t meet this criteria, they will be subject toincome taxesand the 10% penalty. An exception is if you become disabled.

What qualifies as a hardship withdrawal for a 401(k)?

Hardship withdrawals, which avoid the 10% penalty, can be taken for various reasons, including certain medical expenses, tuition, costs related to buying a primary residence or repairs, and funeral expenses.

What is the standard Internal Revenue Service (IRS) penalty for withdrawing 401(k) funds early?

For early withdrawals that do not meet a qualified exemption, there is a 10% penalty. You will also have to pay income tax on those dollars. Both calculations are based on the amount withdrawn. For example, if you are in the 22% tax bracket and take out $10,000, you will owe $1,000 in penalties and another $2,200 in income tax ($3,200 total due, leaving $6,800).

How old do you have to be to cash out your 401(k) without penalty?

For a normal withdrawal, you must be 59½ years of age or older.

The Bottom Line

As you can see from the above example, it makes sense to consider all of your options before dipping into your 401(k) before you can make qualified withdrawals. At the very least, understand what you will come away with after paying the early withdrawal penalty and other taxes that you will owe.

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