Avoiding 401k Plan Penalties

Avoiding 401k Plan Penalties

Avoiding 401k Plan Penalties

A 401k is a long-term savings plan for employees to accrue money for retirement. The term 401k comes from the U.S. Internal Revenue law. Traditional 401k plans are not treated as taxable income until the money is withdrawn, but there are other types of 401k such as Roth 401ks that tax the money at the time of investment.

If an employee leaves an employer for any reason, it is possible the 401k administrator will close out your account and give you a distribution check that can be transferred to another personal pension plan. This payment becomes taxable as soon as you deposit this check. There are very high taxes and penalties that come with cashing out a 401k before the age of 59 1/2, so the best option is rolling over your 401k distribution into an IRA or another 401k with your new employer. An IRA is an individual retirement account that you can set up at your bank and you can find information about rollovers from your 401k at the IRS website.

Essentially, you will be subject to a 10% penalty based upon the amount of money in your account. This penalty is in addition to the income taxes you are expected to pay. Even if you plan to give the money away, the taxes and penalties still apply.

There is an exception to the early withdrawal penalties. Under a financial hardship exception, if you wanted to buy a house (to live in yourself)or protect your home from foreclosure; pay college tuition for yourself or one of your dependents; or pay medical bills that are not reimbursable, you can avoid paying the penalty, but not the interest. To be eligible for the hardship exception means you must meet at least one of the qualifications:

If you have been deemed totally disabled and unable to work, or if you stopped working due to termination, quitting your job or taking an early retirement at or after the age of 55

If you have medical debt that is greater than 7 1/2% of your income. If there is a court order requiring you to surrender the money to someone else, or if you are no longer working, but have an established payment schedule for money withdrawal.

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