The 4-1-1 on 401K withdrawal penalties

This guest post is brought to you courtesy of Leon Harris. He writes for Financialized, an investing and finance blog that offers an unbiased perspective on personal finance topics.

Everyone knows that a 401K is set up almost exclusively as a retirement plan, and as such, it comes with some pretty hefty penalties for early withdrawal (which is to say, before the age of 59 1/2). However, this hasn’t stopped many people from taking funds from their 401K, and finding ways to avoid the astronomical costs of doing so. Whether you’ve lost your job, you’re facing a medical emergency, or you could simply use the extra dough, there may be a way to access your 401K early. But there are a few things you need to know about before you treat your retirement fund like an ATM:

1. Income tax. The first penalty you will be hit with is income tax. Remember, any monies you filter into your 401K enter the account pre-tax. So the moment you begin to withdraw, the money is subject to income tax, just like any other earnings. Not only will you have to pay the government their normal pound of flesh, if your withdrawals happen to bump you into the next tax bracket, you could be facing a lot more expenditure come April 15th.
2. The 10% tax. On top of any income tax you will be required to pay, there is a standing, across the board 10% penalty applied to any funds you pull from your account before the age of retirement. When you think about it, you may as well be flushing that 10% down the toilet. Honestly, even check-cashing services don’t charge that much!
3. Exemptions. Luckily, there are a number of exemptions that will allow you to withdraw money without the 10% penalty (although you absolutely cannot avoid the income tax). Death, permanent disability, loss of employment after age 55, excessive medical expenses, and court-ordered divorce settlements are just a few instances of ways that funds can be withdrawn early without penalty, so you may want to see if you qualify for any of these exclusions (although if you do, you are probably in a pretty sorry state).
4. Borrowing. Some plans also offer a lending option where the 401K is concerned (although this is an addition to the policy that must generally be adopted by the company you work for, and most companies don’t want to pay extra for this feature). If you are lucky enough to have this option, you can pull money early and pay it back like any other loan: with interest (usually based on the prime rate). Of course, most companies restrict the uses for this money to circumstances like paying for schooling, purchasing a home (or staving off foreclosure), and medical expenses, just to name a few.
5. SEPP. A substantially equal periodic payment plan is another way to withdraw funds early, but it, too, comes with some unfortunate side effects. It works like this: you set up an account that pays you a certain amount annually from your 401K as a way to supplement your income, and you don’t have to pay any penalties to do so. Sounds pretty good, right? It is, except for the fine print. Once you set up a SEPP, you can no longer contribute to your 401K, thereby depleting your retirement fund. Plus, you have to continue to withdraw either for five years or until you reach retirement age, whichever is longer.

While you may be tempted to dip into your retirement account early, you are almost guaranteed to take a financial hit if you choose to do so, whether you pay penalties or you simply lose out on the interest that the money could have been earning if you’d left it alone. There are certainly ways to buck the system, but in the long run, you are essentially only hurting yourself when you opt to use your future funds today.