Tax Penalty for 401(k) Early Withdrawal
The issue of early withdrawal from a 401k retirement plan depends on the plan, the age of the owner and the reason for removal of funds. Generally, a 10 percent penalty is added for withdrawals if they occur before you attain 59 1/2 years of age, although certain specified circumstances prevent additional taxes from being charged.
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Retirement Plans
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Retirement plans are of two types: qualified and unqualified. An eligible 401k is a qualified plan. Money that is withdrawn from a retirement plan may or may not be taxable. Additional penalties for removal may apply, depending on circumstances.
Taxation of Distributions
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Generally, withdrawing money from a retirement plan causes a taxable event. You want to minimize your taxes. That requires planning.
Money contributed to a retirement plan can be of two types: "before tax" or "after tax."
Funds you contribute that were previously taxed are returned to you tax-free.
Funds deposited into your retirement account but not previously taxed become taxable on distribution to you.
Earnings generated from both kinds of deposits are taxable to you as ordinary income, upon distribution.
However, the timing of both distributions and contributions can cause additional penalties.
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Early Withdrawal
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The term "early withdrawal" can refer to more than one event. Generally, early withdrawals cause a 10 percent penalty, in addition to regular income taxes.
Removing money before one turns 59 1/2 is the most common cause for the additional 10 percent early withdrawal penalty. But certain early distributions are tax-free, such as rollovers or the return of your after-tax investment contributions.
As to rollovers, if, within the allotted 60-day window, all withdrawn money is "rolled over" into a different retirement plan, the distribution will not be a taxable withdrawal. No regular income tax nor additional 10 percent penalty can be charged.
Prematurely closing of your 401k can cause additional penalties. If, after becoming eligible to receive an annuity, you take payments other than an annuity, this can cause additional penalties.
Exceptions to Early Withdrawal Penalty
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Payments made as a result of your being totally and permanently disabled are exempt from the penalty. Similarly, other exempt distributions can occur after death--or to certain lifelong regular, approximately equal payments, begun prior to your becoming 59 1/2 years of age.
The Internal Revenue Service's instruction manual indicates the 10 percent early withdrawal penalty does not apply to distributions such as qualified disaster recovery assistance; money converted to a Roth IRA; or, as a result of certain excess contributions. The 10 percent penalty, however, is charged against earnings from related excess contributions, if those are withdrawn before you are 59 1/2. Under certain conditions, distributions for higher education, home purchase, an IRS levy or for a domestic-relations order may also be exempt.
Other Penalties
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Borrowing from your individual retirement account, or using your IRA as security for a loan, is a prohibited transaction, causing penalties.
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References
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