401k Penalty Exceptions to Avoid the 10% Penalty

A 401(k) plan is designed for long-term retirement savings. To support this, distributions taken before age 59½ are generally subject to a 10% additional tax. This penalty is applied on top of the ordinary federal and state income tax owed on the withdrawn amount. However, the IRS allows for several exceptions that can waive this penalty in specific circumstances.

Qualifying for a Penalty Exception

Death or Total and Permanent Disability

Distributions from a 401(k) are not subject to the 10% penalty if made to a beneficiary after the account owner’s death. If an account holder becomes totally and permanently disabled, they can also access their funds without penalty. The IRS considers someone disabled if they cannot engage in any substantial gainful activity due to a medically determinable impairment expected to be long-term, indefinite, or result in death. An individual must provide proof from a physician certifying the condition.

Substantially Equal Periodic Payments (SEPP)

An account holder can avoid the penalty by taking a series of substantially equal periodic payments (SEPP). These payments must be taken at least annually and are based on the individual’s life expectancy or the joint life expectancies of the individual and their beneficiary. The payments must continue for at least five years or until the account holder reaches age 59½, whichever period is longer. Modifying the payment schedule before this condition is met can result in the retroactive application of the 10% penalty to all previous distributions.

Separation from Service After Age 55

An employee who leaves their job through retirement, quitting, or being laid off during or after the calendar year they turn 55 can take penalty-free distributions from that employer’s 401(k) plan. This “Rule of 55” only applies to the 401(k) of the employer the individual just separated from. Funds in previous employers’ 401(k)s or in IRAs are not eligible for this exception.

Medical Expense Reimbursement

The 10% penalty does not apply to distributions used for unreimbursed medical expenses that exceed 7.5% of the taxpayer’s adjusted gross income (AGI) for the year. An individual does not need to itemize deductions to qualify for this exception. The amount eligible for the penalty waiver is limited to the medical costs that surpass the 7.5% AGI threshold.

Qualified Domestic Relations Order (QDRO)

When a 401(k) is divided in a divorce, funds distributed to an alternate payee, like an ex-spouse, are not subject to the 10% penalty. This division must be executed under a Qualified Domestic Relations Order (QDRO), a legal order related to the settlement. The QDRO specifies the amount or percentage of the benefits to be paid to the alternate payee.

IRS Levy on the Plan

If the IRS places a levy on a participant’s 401(k) to satisfy unpaid federal taxes, the distribution made to the government is not subject to the 10% early withdrawal penalty. This exception is automatic and applies directly to the amount seized by the IRS.

Qualified Reservist Distributions

Members of the military reserve called to active duty for more than 179 days may be eligible for penalty-free distributions. These qualified reservist distributions can be made during the period beginning on the date of the order to active duty and ending at the close of the active duty period.

Qualified Disaster Recovery Distributions

Individuals with an economic loss from a federally declared disaster may take a qualified disaster recovery distribution. This allows penalty-free withdrawals of up to $22,000 from a retirement plan. The distribution must be made within a specific timeframe following the disaster declaration, and the amount can be repaid over three years to avoid income tax consequences.

Terminal Illness

A distribution to an individual certified by a physician as having a terminal illness is exempt from the 10% penalty. A terminal illness is defined as one reasonably expected to result in death within 84 months of the certification.

Distributions for Victims of Domestic Abuse

Victims of domestic abuse can take a penalty-free withdrawal by self-certifying their status. The withdrawal is limited to the lesser of $10,000 (indexed for inflation) or 50% of the vested account balance. The distribution must be taken within one year of the incident of abuse.

Emergency Personal Expense Distributions

One penalty-free withdrawal of up to $1,000 is allowed per year for immediate financial needs related to personal or family emergencies. The taxpayer can repay this distribution within three years. If not repaid, no further emergency distributions can be taken from that account for the following three years.

How to Report an Exception to the IRS

To claim a penalty exception, you must file IRS Form 5329, “Additional Taxes on Qualified Plans,” with your annual tax return. On this form, you will report the total early distribution and the amount that is exempt from the penalty.

You must also enter a specific code from the form’s instructions that corresponds to your qualifying exception. This code informs the IRS why the distribution is not subject to the 10% tax. Failing to file Form 5329 may result in the IRS assessing the penalty and sending a notice for the unpaid tax.

Plan-Specific Rules and Limitations

An IRS-approved penalty exception is separate from your 401(k) plan’s rules for allowing distributions. While the IRS may permit a penalty-free withdrawal, your employer’s plan is not required to allow you to take money out for that same reason, especially while you are still employed. Each plan has its own rules dictating when participants can access funds.

Many plans offer “hardship distributions” for an immediate financial need. However, a plan-approved hardship withdrawal does not automatically exempt you from the 10% penalty. The reason for the hardship must also align with one of the specific IRS exceptions to avoid the tax.

Before taking a distribution, you must determine what your plan allows. Contact your 401(k) plan administrator or review the Summary Plan Description (SPD), which outlines the plan’s rules. This will clarify which types of in-service distributions are permitted.