How to Determine Penalties for 401(k) Early Withdrawals
Early withdrawals from a 401(k) retirement plan -- those made before turning 59 1/2 years of age -- are subject to income tax, and often additional penalty as well. The objective is to keep you from treating a 401(k) as a short-term cash source. Although not technically a penalty, the money you will lose in compound earnings also is something to consider.
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Determine Your Income Tax Rate
Your current income tax rate is a starting point for determining both the tax and penalty fee due. The rate applies only to taxable income -- net wages after subtracting pre-tax deductions such as 401(k) contributions and group health insurance payments -- and varies according to your filing status. Most tax preparation and many personal finance websites have calculators for determining your income tax rate.
Deduct Income Taxes
An early withdrawal usually results in a larger tax bill because you’re paying a higher income tax rate. 401(k) contributions are tax-deferred, meaning the Internal Revenue Service charges income tax on withdrawals, not on contributions. For example, if you’re in a 25 percent income tax bracket and withdraw $10,000 from your 401(k), the income tax due will
be $2,500. However, if you withdraw the same amount at a 15 percent rate after reaching age 59 1/2, the tax due falls to $1,500. Essentially, you’re paying a $1,000 income tax penalty on the early withdrawal.
Add the Penalty Fee
Determine whether the withdrawal is subject to a 10 percent penalty. If it is, multiply the amount of the withdrawal by 10 percent. For example, the penalty fee on a $10,000 withdrawal is $1,000. However, the fee doesn’t always apply. Refer to tax topics information on the IRS website to determine whether a penalty fee applies to your situation. For example, early withdrawals for qualified higher education expenses are exempt from the penalty and qualified first-time home buyers can withdraw up to $10,000 penalty-free.
An early withdrawal can be costly in terms of lost interest. If you left the $10,000 in your 401(k) for an additional 10 years instead of taking an early distribution, you’d have an additional $3,439.16 at a 3 percent annual return rate and $6,288.95 at a 5 percent rate. Investor.gov and most personal finance websites have compound interest calculators for determining how much you stand to lose or gain.Source: ehow.com