401k plans are a common mechanism of funding retirement. These plans are administered by an employer, who matches some proportion of an employee’s contributions to the plan. Because the plans are intended to fund retirement and receive preferential tax treatment, there are typically penalties for withdrawing funds before age 59 1/2.
401k Plan Structure
The contributions of an employee to a 401k plan are tax-advantaged in that the contributions are made before taxes are paid on income. For example, if you contribute $3,000 to your 401k any given year, you will not have to pay taxes on that $3,000 of income that year. Taxes will not be due on this amount until funds are withdrawn from the 401k plan. This gives the immediate advantage of some tax relief and the long-term advantage of compounding growth of funds.
Early Withdrawal Penalties
Funds that are withdrawn from the fund early are subject to a 10 percent penalty. As of 2010, the benchmark for “early” is before age 59 ½. No matter when the funds are distributed, taxes will be due whether the distribution is early or not.
While individual 401k plans are administered by the companies that offer them and thus vary, most employers will allow you to borrow against the vested portion of your 401k. As with most loans, funds that must be repaid at a later date are not considered income and thus not taxed. However, if the loan defaults, it is considered an early distribution and is subject to taxation and the 10 percent penalty.
Certain circumstances, usually due to hardship of some kind, may qualify you to withdraw funds from a 401k plan without this penalty. Significant medical expenses (the IRS considers “significant” to mean greater than 7.5 percent of your annual income) may allow you to withdraw from the plan without penalty. These expenses must be deductible, though you need not itemize your return for that year. Total or permanent disability or death will also trigger the release of funds without penalty to yourself or your spouse.
There is also a tax loophole that allows you to withdraw without penalty starting at any age as long as certain factors apply. The principle “substantially equal periodic payments” demands that you take a payment of approximately the same amount from the plan once per year, for at least five consecutive years. After five years and one day of the first withdrawal, unlimited withdrawals free of penalty are possible. If this schedule is not rigorously adhered to, retroactive penalties and taxes will apply.