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401K Tax Penalty
A 401(k) is a way to reduce your taxable income. When you contribute to 401 (k), the contributions come from your pay before taxes are deducted. The money you save in 401 (k) is not taxable and it can grow quite substantially. The good news is that many 401 (k) plans have matching contributions from the employer. |
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On one hand 401 (k) allows your money to compound more quickly than it would if it were taxed annually. On the other, it can be quite expensive to take out money from a 401 (k) plan before your retire. You will be subject to 401 (k) tax penalty should you withdraw money before retirement.
If you withdraw money from a 401 (k) before reaching the age of 59-1/2, you would be liable to pay income tax along with a 10 percent penalty. And the time lost for compounding your savings will have significant reduction in your nest egg.
If you are changing your job, you have usually three choices with regard to your 401 (k). You can leave the money where it is, cash out, or roll it over to another 401 (k) plan or into an IRA. If your 401 (k) account holds less than $5,000, your employer might insist that you take out the money from the plan. However, that would be a bad idea. Remember, even the smallest amounts can grow large with time and tax-deferred compounding. You should always try to roll the money into another retirement plan.
When you roll the money into another retirement plan, do not forget to make a trustee-to-trustee transfer. If you do not do it, you would face the risk of paying tax penalties on your 401 (k) amount.
However, there is an IRS rules which allows early withdrawals from your 401 (k) without facing penalties. You can take a fixed amount for five years or until you reach 59-1/2 depending on which is longer. The annual withdrawal amount is fixed based on your life expectancy. This IRS rules is called 72 (t).
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