401(k) Early Withdrawal of Funds - Penalties, Exceptions, IRS Rules & Distribution Codes for Form 1099

(October 20th, 2008)

Most retirement investors know that if you withdraw funds from your 401(k), traditional IRA or 403(b) plan before the age of 59 and 1/2, you will be charged with a 10% early distribution penalty; however there are always exceptions to this rule. Also, this rule does not apply to Roth IRA, you can withdraw as much of what you have contributed to your Roth IRA as long as your plan has been in existence for atleast 5 years.

Thus if you withdraw $5000 from your 401k plan at the age of 45, you will have to pay a $500 penalty, as well the $5000 will be included in your taxable income when you file taxes; a double whopper! Therefore, it is essential to know the rules & exceptions you have to work your way around this and borrow from your 401k plan without facing an early distribution penalty. You cannot however prevent the $5000 withdrawal from being included in your taxable income during tax time, unfortunately!

If you withraw money from a Simple IRA that you started contributing to only 2 years ago, the early distribution penalty is increased from 10% to 25%! The additional tax on early 401k distributions is filed on Part 1 of IRS Form f5329

Exceptions for Early Withdrawals from 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

Exceptions for Early Withdrawals from a Qualified 401(k) or 403(b) Plan

- Withdrawals upon death or disability of plan investor
- You are 55 or over and quit your job
- Distributions received over lifetime as "substantially equal payments"
- Medical expenses exceeding 7.5% of your adjusted gross income
- The distributions were required due to a divorce agreement or settlement

Useful Resources

>>> Instructions for Form 5329 - Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts

>>> Instructions for Form 1099-MISC

>>> Topic 557 - Tax on Early Distributions from Traditional and ROTH IRAs

>>> Topic 558 - Tax on Early Distributions from Retirement Plans

>>> Early Distributions - Publication 590