How to Take Penalty-Free Withdrawals from Your 401(K)

Let’s start with interesting statistics: only 25% of Americans live just on a state pension. The vast majority of the US population is saving money for retirement in advance.

In addition to the traditional state pension (Social Security) in the United States, there are several alternative voluntary retirement plans. Due to them an employee or employer (or jointly) contributes a certain sum of money to the employee’s individual retirement account every month.

Pension plans are very flexible. Some of them allow you to invest the accumulated funds at the discretion of the employer. Others make employees take an active part in this process as well. 

These plans also have different income tax conditions. Even banks usually take into account the type of pension plan and the amount of money you have when issuing a loan. Retirement account funds are exempt from taxes.

However, if the owner of the plan decides to withdraw money before reaching the retirement age, then he or she will have to pay taxes and an additional penalty on them. At the same time, if the early withdrawal is used to purchase a house or to pay for school, taxes, and penalties are not paid.

There are several alternative options to a traditional pension and today we will get a closer look into the most popular retirement plan – 401k (Four-oh-one-kay). So, here we go!

What Is a 401(K) Plan

401(k) plans are extremely popular among Americans nowadays. Due to this option money can be saved on your account by both the employer and employee. The whole investment process is ruled by the last one.

An employee can deposit up to 15% of his salary to a personal retirement account. At the same time, the employer can contribute to this account a certain percentage of the employee’s deductions. It is usually between 30 and 50%. 

Although, 401k conditions differ from one situation to another. Thanks to this retirement plan people feel more secure. It allows Americans to overcome financial anxiety and get prepared for unexpected challenges.

How Does It Work? 

To get a better understanding of the 401(k) plan, let’s consider how it works.

  • The employer opens a 401(k) plan so that you can reduce taxable income and invest your money.
  • The employer makes a so-called match. It means that if you contribute, for example, 7% of your salary to a 401k account, the employer adds the same amount to your account. Usually, the contract specifies up to what percent the employer will do the match.
  • You can invest the money saved on your account in securities. Well, it will be better to say that you can invest in specially formed portfolios of securities (you determine the level of risk and revenue by yourself).

What Types Of 401(K) Plans Are There? 

There are several types of a 401(k) retirement plan. In most cases, the borrower can mix different options for getting maximum results. So, you can make use of the following pension plans:

  • Traditional 401(k) plans
  • Safe harbor 401(k) plans
  • SIMPLE 401(k) plans
  • Solo 401(k) plans
  • Roth 401(k) plans

But how can you understand which type is the most beneficial exactly for you? To make it possible, let’s find the difference between them.

Traditional 401(k) Plan

The Traditional 401(k) plan is based on the principle that employees contribute a percentage of their wages before taxes to their 401(k) accounts. This model is very popular among companies of different sizes and types. To make you feel more secure you can also set up a schedule of the employee’s payments and define a particular period of its validation.

You should know that the sum of money a person has to invest into the 401(k) account isn’t stable. It usually changes each year. For 2022 it is up to $20,500 that you can save on your 401(k).

What’s more, people after 50 years old can also make use of additional catch-up contributions. It also changes annually. For this year it is up to $6,500. In such a way the employer and employee savings cannot exceed the annual limit.

Safe Harbor 401(K) Plan 

This plan automatically passes the non-discrimination test or bypasses it altogether. It is relatively easy to do, but the employer must contribute the same percentage of wages for o every employee’s plan. 

For example, for each employee’s contribution, the company adds another 5% of their salary. The corresponding amount will depend on your contribution as a business owner.

A safe harbor plan is more popular among small companies because it helps to save time and money on annual tests. On the other hand, due to this plan, the employer is obliged to contribute to the 401(k) accounts of each worker.

The contribution limit there is the same as a traditional option. In 2022 the employees can transfer on their retirement plans no more than $20,500 and $6,500 in terms of additional contribution.

Simple 401(k) Plan 

It is another option popular among small companies that employ less than 100 workers. Its name speaks for itself. A simple 401(k) plan is a simplified adoption of a traditional retirement plan. 

Due to it, all employee’s contributions are nonprofitable. But there is one great disadvantage. You cannot take advantage of the contributions and revenues from any other employer-sponsored retirement plan.

A simple 401(k) plan is usually changed every 2 years. As an employee, your contribution can’t exceed $14,000 in 2022. As we remember, if you are older than 50 years old, you can make additional contributions. This year this sum is up to $3,000.

Solo 401(K) Plans

Solo 401K is a retirement plan for business owners who do not employ workers. To be eligible for the Solo 401K plan, you must be the sole owner of the company, although a spouse may be included in the plan. You also shouldn’t expect other employees to work in your business in the future.

The Solo 401K pension plan offers many benefits. For example, it allows you to take a loan. If you already have $100,000 in the plan, you can apply for a $50,000 loan. 

You are also allowed to deduct your Solo 401K contributions from your taxes and the Solo 401K investment will be based on a deferred tax basis. Employees can contribute up to $20,500 and people over 50 years old can make up to a $6,500 catch-up contribution this year.

Roth 401(k) Plan 

Roth 401(k) is sponsored by the after-tax money. It is possible up to the limit of the circuit’s contribution. This type of retirement plan aims at helping individuals who may be subject to a higher and excessive tax rate after retirement. 

This may be achieved thanks to the ability to withdraw money without taxation. Just like the traditional option, this one also includes a non-discrimination test. Roth plan is used by businesses of any size.

The limits are the same as the traditional 401(k) plan. In 2022 you are supposed to contribute to your account no more than $20,500. If you have a right to make additional payments it shouldn’t exceed $6,500. Remember that these figures change each year and be attentive.

How to Make a Penalty-Free Withdrawal from a 401(K)? 

Well, if you want to make a 401k withdrawal before retirement you should be aware of possible taxation and even penalties. Luckily for you, there are some kinds of emergencies that allow making penalty-free early withdrawals. 

Make sure you understand the difference between taxes and penalties since the first ones are paid almost in all cases. Traditional 401(k) withdrawals are usually taxed due to ordinary interest rates. 

As a rule, a person can make use of money from a retirement account without paying penalties and taxes if the account has been opened for more than 5 years. (provided it is written down in the employer’s plan.

But how can a person make a penalty-free withdrawal from a 401(k)? Let’s focus on these exceptions.

Unreimbursed Medical Bills

Healthcare is important although not cheap. Sometimes you can face unexpected medical expenditures that will be difficult to afford. According to governmental laws, investors can withdraw the required sum of money from their retirement plan to cover their unreimbursed medical expenses. 

The essential condition there is that these bills must exceed 10 percent of the gross income. If you want to make an early withdrawal with this aim, make sure your medical bills were incurred within this year. The same with healthcare insurance. 

Inability to Work

Disability is a term referring to a person who, due to illness or accident, has lost (or partially lost) the ability to function as an employee.

According to 401k withdrawal rules, you can make use of the money from your retirement plan without paying a penalty in case you can’t work due to some medical reasons. If the investor is permanently or totally disabled he or she can make a withdrawal for covering medical expenses and just making their ends meet. 

You should understand that to get such a right you must offer a document that certifies your disability. It is usually easy to prove the person’s inability to work by providing corresponding payments from an insurance company.

Health Insurance Premiums 

Health insurance is a type of personal insurance that guarantees you, in the event of an insured event, receiving medical care and compensation for the cost of purchasing medicines at the expense of an insurance company.

Since this kind of emergency happens quite often investors can withdraw money from their 401(k) accounts even before they retire. To make it possible your unreimbursed medical expenses must encompass more than 10% of your adjusted gross income in the current year.

First-Time Home Buyers 

You have a right to a penalty-free withdrawal from your 401(k) plan if you are going to buy your first house. It is interesting to know that a person can make use of this service several times. But the available sum is limited to $10,000. 

What’s more, in this context “first-time home” is not something you can imagine. This notion is not defined clearly. If during the last two years you didn’t have any home possessions, then you can make use of this option. If you are married, your spouse can also do it.

Higher Education Expenses 

You may be lucky to know that you can make an early money withdrawal from your retirement plan to cover expenses on higher education. It includes fees, books, tuition, and the like. In this case, you won’t be charged a penalty. 

At the same time, be ready to pay tax for an early withdrawal. What’s more, you can use this strategy to pay not only for your but also children’s or spouse’s education. Sounds appealing, doesn’t it?

How Much Tax Will I Have to Pay on Early Withdrawals from My 401(K)? 

One of the most beneficial advantages of a 401(k) plan is that each of your contributions brings tax benefits. However, these tax credits apply only if you comply with the plan’s rules. 

According to them, you can make use of saved money only after reaching 59 years old. If you need the money much earlier in some cases you are allowed to make a penalty-free withdrawal. (We have mentioned it above) 

On the other hand, if you need money for other purposes, you will be charged regular income taxes on this service. It is usually 10% but in some cases may be up to 35%. The percentage is usually defined by a tax rate in a year you have taken a distribution.

Conclusion 

Life is unpredictable. To avoid financial anxiety and get prepared for the future it is essential to think about your retirement. Thanks to a 401(k) plan you can save a significant sum of money with the flow of time and use them after you reach 59 years old. 

But if you need them earlier, you can withdraw them. In some cases, that we have mentioned above, you won’t be charged a penalty. But on most occasions be ready to pay an interest rate plus a 10% charge.

Anyway, the understanding of state pension alternatives is essential for making maximum use of your finances. Remember that the earlier you start thinking about your old age, the more independent and satisfied you will be in the future.

FAQ

At What Age Is 401k Withdrawal Tax-Free?

A person can withdraw money from 401(k) contributions without paying a penalty after she or he turns 59 years old. To make use of this option the retirement account must have been opened for at least five years. If you want to make an early withdrawal for a purpose that is not defined in the exceptions, you will have to pay taxes.

How Do I Report a Covid 401k Withdrawal on My Taxes?

According to the IRS, you will need to report your Covid 401k withdrawal on your taxes as ordinary income. This means that you will be taxed on the money that you withdraw at your marginal tax rate. If you need to report the repayment of a Covid-19-related distribution or to specify the sum of any coronavirus-related distribution, make use of the 8915-E form.

What Happens If I Don't Report My 401k Withdrawal?

According to current legislation, such actions will lead to additional penalties. If you don’t submit your withdrawal forms for the current year to the Internal Revenue Service, be ready to face a federal income tax of 10 percent.

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