Calculating A 401k Early Withdrawal Penalty

The 401k early withdrawal penalty
If you withdraw money from your 401k retirement plan before your reach the age of 59 and 1/2 years, you will have to pay a penalty on the taxable amount, which is known as 401k early withdrawal penalty. You will also have to pay income tax on the "early withdrawal" amount from your 401k. To calculate your 401k early withdrawal penalty, you need to understand two components of early withdrawal. The first one is how to calculate the federal and state tax that will be come due. The second is the tax penalty on early withdrawal, included in most plans. Below you will find the method for calculating your 401k penalty.

Step1 - Federal Tax Due: Determine what federal tax rate you are paying. Once you take the money out of the 401k it is considered income, as the withdrawal is from money that is pre-tax, and must be taxed. The federal income tax rate runs from roughly 15 percent to 35 percent for the majority of Americans. To find your tax bracket, check your previous tax returns and also make sure that your withdrawal does not propel you into a new tax bracket. For example, if you take out $30,000 from your plan, you will have to pay $6,000 as a penalty if your tax rate is 20%, assuming that the distribution is all income.

Step2 - State Tax Due: In this step, you will have to determine the state income tax bill on the 401k withdrawal. Check the state income tax you paid the previous year, as this amount of money should be accounted for as well. From the example above, if you state income tax rate is 5%; you will pay $1,500 to the state on the income of $30,000.

Step3 - Early Withdrawal Penalty: Add 10 % to the amount of the withdrawal you are making to get your final penalty. IRS rules generally states that you are charged 10% as an early withdrawal penalty, unless you qualify for some exception. This amount will be in addition to the taxes mentioned above. For instance, if you are taking $30,000 and are in a 20 percent tax bracket in a state with 5 percent income tax, your $30,000 withdrawal will net you less than $20,000. You lose $3000 for the penalty, $6000 for the federal income tax and $1500 for the state income tax.

Determine whether you qualify for an exemption from the penalty, as in certain instances, you can access your money early without paying the taxes.

Potential exceptions to early 401k withdrawal penalties

• Distributions upon the death or disability of the plan participant.
• Retirement at or after the age of 55.
• You received the distribution as part of "substantially equal payments" over your lifetime.
• You paid for medical expenses exceeding 7.5% of your adjusted gross income (You do not need to itemize in order to claim the medical expense exception).
• The distributions were required by a divorce decree or separation agreement.

Potential exceptions to early withdrawal penalties from a Traditional IRA

• If the IRS levies your IRA for any tax debts you owe.
• If you paid for medical expenses exceeding 7.5% of your adjusted gross income.
• If you buy a house (you must NOT have owned a home in the past 2 years and there is a maximum limit of $10,000).
• If you pay for college fees for yourself or dependents (higher education expenses).
• If you were unemployed and paid for health insurance premiums.
• If you are permanently disabled or injured.
• If you received a lump sum payment but rolled the money over to a qualified retirement plan such as a Roth IRA within 60 days.
• If you had a direct rollover to a new retirement account.

The 401k early withdrawal should be seen as a last resort. The best option to save you from 401k withdrawal penalty is to inquire about the possibility of obtaining a 401k loan; such loans are not subject to tax and penalties. The good news is that you will not have to pay 401k early withdrawal penalties if you withdraw money when you leave your company, the same year you reach the age of 55 years or greater.