The 10% penalty on early withdrawals from a 401k plan can be avoided if the owner meets one of five conditions, including disability, excessive medical costs, divorce, retirement or “substantially equal” periodic withdrawals. 401k plans are pre-tax savings plans for retirement, with a wide variety of investment options. Any growth is not taxed until withdrawal, which is taxed as ordinary income. The penalty is intended to discourage early withdrawals, but exemptions exist for certain circumstances.
The 401k withdrawal penalty, which is 10 percent of any withdrawal from a 401k savings plan before the owner turns age 59½, can be avoided if at least one of the following five conditions is met: the owner you are disabled or die before age 59 1/2, the withdrawal is made to cover excessive medical costs, the withdrawal is ordered as part of a divorce decree or separation agreement, the owner retires or is laid off at age 55, or more, or “substantially equal” periodic withdrawals are paid to the owner.
A 401k plan is an employer-sponsored savings plan in the United States, generally intended to be a component of an employee’s retirement savings program. Funds are withheld on a pre-tax basis from workers’ individual pay and contributed to their 401k accounts, subject to limitations imposed by the Internal Revenue Code (the Code). Some employers also match some or all of their employees’ contributions. There is a wide variety of presumably safe products in which to invest 401k accounts. Any growth, whether due to capital gains or interest income, is not taxable until the funds are withdrawn. When funds are withdrawn or distributed, they are taxed as ordinary income at the owner’s then applicable tax rate.
Since 401k plans were established to give taxpayers a way to save tax-deferred for retirement, the 10 percent penalty on distributions before that age is intended to discourage taxpayers from reducing their retirement savings for other purposes. However, in the event that the account owner meets one of the five circumstances defined by the Code before reaching age 59 1/2, he or his beneficiary may receive distributions without incurring the penalty.
If the owner dies or becomes disabled before age 59 1/2, distributions can be made without penalty to either the disabled owner or beneficiaries, as applicable. Another exemption is for payment of medical costs that exceed 7.5 percent of the owner’s adjusted gross income (AGI). In addition, when a couple divorces, 401k accounts are often a significant component of marital assets, and a qualified domestic relations court order, essentially a divorce decree or separation agreement, can order the distribution of a portion of the account to the owner’s spouse’s account These distributions are exempt from the 401k withdrawal penalty.
The Code allows distributions before age 59½ for individuals who retired, quit, or were laid off at age 55 or older, but only with respect to that ultimate employer-sponsored 401k account. Distributions taken from other 401k accounts are still subject to the early withdrawal penalty. This is a good reason to close old 401k accounts and consolidate them.
One last way to avoid a 401k withdrawal penalty is called the “substantial equal payments” exception. Called a Section 72
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