How to Avoid the 10% Penalty on a 401(k) Withdrawal
Learn the distinct rules and procedures for accessing 401(k) funds before retirement age without triggering the common 10% early withdrawal penalty.
The Internal Revenue Service (IRS) imposes a 10% additional tax on early distributions from qualified retirement plans like 401(k)s. If you withdraw funds from your 401(k) before age 59½, you will face this penalty on top of regular income tax on the withdrawn amount. However, the tax code provides several exceptions for this penalty. These provisions offer financial flexibility for significant life events, provided the strict criteria for each exception are met.
Penalty Exceptions Available Directly From a 401(k)
Several exceptions allow for penalty-free withdrawals directly from a 401(k) plan. Under the separation from service rule, if you leave your job during or after the calendar year you turn 55, you can take distributions from that employer’s 401(k) without penalty. For qualified public safety employees, like police officers and firefighters, this age is lowered to 50. This exception applies only to the 401(k) of the employer you just left.
An exception exists for a total and permanent disability. You must be unable to engage in any substantial gainful activity due to a medically determinable impairment that is expected to result in death or be of long-continued duration. This typically requires a physician’s certification. If the account holder dies, distributions taken by their beneficiary are also exempt from the 10% penalty.
The tax code permits penalty-free withdrawals through Substantially Equal Periodic Payments (SEPP), which provides a series of payments over your life expectancy. There are three IRS-approved methods for calculating these payments. Once you begin a SEPP plan, you must continue it for at least five years or until you reach age 59½, whichever is longer. Changing the payment schedule before this time results in the retroactive application of the 10% penalty to all amounts withdrawn.
You can withdraw an amount to cover unreimbursed medical expenses to the extent they exceed 7.5% of your adjusted gross income (AGI). The distribution must occur in the same year the expenses are paid. If funds are paid from your 401(k) to an alternate payee, such as an ex-spouse, under a Qualified Domestic Relations Order (QDRO), the penalty does not apply to that distribution.
Recent legislation created new exceptions, though they are optional for employers to adopt. You may take a distribution of up to $1,000 per year for unforeseeable personal or family emergency expenses. Victims of domestic abuse can withdraw up to $10,000 (or 50% of their vested balance, if less) within one year of the incident.
Other situations that may qualify for an exemption include:
- An IRS levy on the account to satisfy a federal tax debt.
- Distributions for qualified military reservists called to active duty.
- Withdrawals up to $22,000 for those in federally declared disaster areas.
- Distributions for individuals with a terminal illness.
- A withdrawal of up to $5,000 per child within one year of a qualified birth or adoption.
Using an IRA Rollover to Access Other Exceptions
To access a different set of penalty exceptions, you can move funds from a 401(k) to a Traditional Individual Retirement Arrangement (IRA). This is done through a direct rollover, where the plan administrator sends the money to the IRA custodian. A direct rollover does not trigger taxes or penalties. Once in the IRA, the funds are governed by IRA rules, which have exceptions not available to 401(k)s.
After a rollover, IRA funds can be used penalty-free for a first-time home purchase, with a lifetime maximum of $10,000. A first-time homebuyer is someone who has not owned a principal residence in the two years before acquiring the new home. The funds must be used to buy, build, or rebuild a first home for yourself, your spouse, children, or grandchildren.
An exception unique to IRAs is for qualified higher education expenses. You can take penalty-free distributions to pay for tuition, fees, books, and supplies for yourself, your spouse, children, or grandchildren at an eligible institution. There is no dollar limit on this exception beyond the total cost of the qualified expenses.
IRA rules also allow an exception for paying health insurance premiums while unemployed. To qualify, you must have received unemployment compensation for 12 consecutive weeks. The withdrawal can pay for premiums for yourself, your spouse, and dependents, but cannot exceed the amount you paid for the insurance.
How to Report a Penalty Exception to the IRS
When you take a 401(k) distribution, your plan administrator reports it on Form 1099-R. This form details the distribution amount and any taxes withheld. Box 7 of Form 1099-R contains a code indicating the reason for the payment.
The code in Box 7 is the administrator’s initial assessment; for example, Code 1 signifies an early distribution with no known exception. If you qualify for an exception the administrator was unaware of, you can still claim it on your tax return. You must inform the IRS that you meet the requirements for a penalty waiver.
To claim an exception and avoid the 10% tax, you must file Form 5329 with your annual Form 1040 tax return. On this form, you report the total amount of your early distributions. You then enter the amount that qualifies for an exception on the designated line.
Next to the exempt amount, you must enter the specific exception code that corresponds to your situation, such as ’02’ for a SEPP or ’03’ for disability. Correctly completing Form 5329 calculates the portion of the distribution subject to the penalty. This form officially communicates to the IRS why you are not liable for the additional tax.