ScaredyCatGuide to the 401(k) - Part 13: Conditions of Early Withdrawal

Most financial professionals advise keeping the money you have socked away for retirement invested in your 401(k) and other retirement accounts. Taking that money to pay a mortgage, student loans or other expenses is not the best use of investment funds.

Often those funds are worth more over the long-term due to compounding growth, even if you are unemployed and no longer able to contribute. For those that are still employed and considering early withdrawal, the future contributions from you and your employers make those funds even more valuable.

Conditions of Early Withdrawal

The “upfront costs” are important to consider as well. These three factors should be understood before making a decision on early withdrawal:
• Penalties
• Taxes
• Vesting

PENALTIES

The penalty from the IRS for early withdrawal is 10% of the total value. If you do not meet the minimum age of 59 ½ cashing out your 401(k) incurs this penalty and you will be required to pay it at tax time.

Some exceptions do exist. For instance, there is the rule of 55. If an employee retires or gets fired at any point in or after the calendar year they turn 55 years old, they are allowed to take penalty free withdrawals from their 401(k) account with that employer. Any accounts with previous employees do not qualify though. You would have to wait until the normal 59 ½ age limit on those.

Rule 72t or “substantially equal periodic payments” is another exception and is available to anyone, regardless of age.

Picture it like setting up an annuity funded by your 401(k). It consists of a series of distributions that are “substantially equal” in amount and based on your life expectancy.

Once distributions begin they must continue for a period of five years or until you reach 59 ½, whichever is longer. Often this option gives you the smallest retirement payouts available being it is based of life expectancy.

Definitely leverage a professional when exploring this option to ensure you do not trigger the penalty.
Additional exceptions exist, most of which are tied to less than desired events. Upon divorce if a court requires funds to be provided for a spouse or dependants, the 10% penalty is waved.

Medical expenses that exceed 7.5% of your adjusted gross income in the same year can be paid for from a 401(k) without penalty as well.

TAXES

In addition to the penalty you also need to pay taxes on the money. The full amount withdrawn is taxed before the 10% is taken out. This can be significant, but usually doesn’t get paid until taxes are filed for that year.

Also, if this puts you in a higher tax-bracket it might be in your best interest to consider adjusting the withdrawal amount or rolling it into some other type of tax deferred savings plan, like an IRA.

The tax on withdrawals occurs with traditional 401(k) plans, regardless of age. If you recall, traditional plans use pre-tax dollars to invest, thus withdrawals are treating as ordinary income and tax is paid according to your tax rate. On the other hand, Roth 401(k) plans use post tax dollars, making withdrawals tax free. The 10% penalty is paid on early withdrawal regardless of the plan type.

VESTING

Vesting in 401(k) plans basically means ownership. When funds are “fully vested” they are yours to keep. Just about every employer that offers contribution matching has a vesting schedule.

These schedules can progress or be all or nothing based on a specific duration. Immediate vesting has become more and more popular in recent years. This is great for employees because the employer contributions get locked in as they are made.

Vesting schedules running two to four years had been the standard for many years, which is still generous compared to what the law requires.

The Pension Protection Act of 2006 set minimum limits on vesting:
• After one year of service: 0 percent vested
• After two years of service: 20 percent vested
• After three years of service: 40 percent vested
• After four years of service: 60 percent vested
• After five years of service: 80 percent vested
• After six years of service: 100 percent vested

Either way, be certain to check your vesting schedule, especially if you plan on leaving your current employer or cashing out your 401(k) account.

Posted Using LeoFinance

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