How Does the 10 Percent 401k Tax Penalty Work?
Particularly if you work for a large company, your employer may offer you a 401k plan as a benefit. A 401k plan is an investment plan intended for retirement savings that carries various tax advantages.
The IRS regulates 401k plans and enforces penalties if plan rules are not followed. One of the most well-known of these penalties is the 10 percent penalty for early withdrawals.
10 Percent Penalty
As a 401k plan is designed for long-term retirement investing, the IRS imposes a penalty if you withdraw any funds before you reach a typical retirement age. Specifically, any withdrawals you take before you reach age 59 1/2 are subject to a 10 percent early withdrawal penalty. This penalty is in addition to any taxes you may have to pay on your withdrawal.
With an individual retirement account, you can take a distribution whenever you like. However, with a 401k you must fall into one of a limited number of permissible categories to take a distribution, even if you are willing to pay the 10 percent early withdrawal penalty.
The IRS permits 401k withdrawals only in the case of disability, death, a severance from employment, if you turn 59 1/2 or incur a financial hardship, which includes medical expenses, tuition and buying a home. You can also take a distribution if your employer’s plan terminates without a successor plan in place. Beyond these options, you cannot take a straight distribution from the plan.
Reporting the Penalty on Your Taxes
If you take a distribution from your 401k plan, you must report the amount on your taxes, including the penalty, if applicable. Compute the amount of your tax penalty on Form 5329, “Additional Taxes on Qualified Plans.” If this form indicates that you owe the 10 percent penalty, transfer the amount of the penalty that you computed on Form 5329 to line 58 for Form 1040.
Rollovers and Loans
Rollovers and loans are not technically distributions from a 401k, so they are not subject to either income taxation or the 10 percent early withdrawal penalty. The exception is if you have a loan and separate from service with your employer, in which case you must pay the loan back within a relatively short time period or have the loan treated as a distribution. In this instance, you may face applicable taxes and penalties.