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A 401(k) is an employer-backed and sponsored retirement account named after the relevant portion of the IRS code that governs these kinds of accounts. Here is how it works. When you get a job that has a benefits package, one of your benefits is likely to include a 401(k) (or 403(b) if you work for a non-profit organization - the same rules apply. Your employer, on your behalf, will take away a certain amount that you agree to (up to the maximum allowed by law and or by the particular plan) from your paycheck each month and invest this in a retirement account. This is pre-tax money that grows tax-deferred until you are ready to withdraw these funds during retirement.
Some employers will also match your monthly contributions up to a certain amount. For this reason alone - the fact that your employer provides you with free money - you should be participating in your company's 401(k) plan. It is advisable to at least make contributions up to the maximum matched by your employer.
Below you'll find some tips on calculating 401k early withdrawal penalties.
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Making an Early Withdrawal From Your 401(k)
Under normal circumstances, your 401(k) retirement funds are supposed to grow over the period of your working life untouched until you retire and are ready to start withdrawing your money. Federal regulations stipulate that you can start withdrawing from the age of 59 1/2. Your withdrawals will be taxed at the current tax rate for your income level because they are considered taxable income.
If you make an early withdrawal for any reason before you are 59 1/2 years old, not only will you pay income tax on your withdrawal, you will also pay a 10 percent penalty. For example if you withdraw $20,000 from your 401(k) at age 59, and you are within the 28 percent tax bracket, you will pay a total of $7,600 to Uncle Sam.
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Borrowing From Your 401(k)
Another advantage of having a 401(k) account is that you may be able to borrow from it instead of the bank. However, this option should only be accessed as a last resort and for only very important reasons. Some people borrow from their 401(k)s to get cash for a down payment on a home while others use it for extreme emergencies such as medical expenses. You need to be very careful when you do this because there is a danger if you are not sure of your job being secure for the long term.
If you lose your job or change jobs, the loan you took out on your 401(k) becomes immediately payable with interest. If you are unable to pay, it will be treated as a withdrawal by the IRS. Therefore, you will owe income tax on the amount you borrowed plus you will also owe a 10 percent penalty if you are under 59 1/2 years old.
Further, even if you do not change jobs, the interest you pay on the loan comes from your after-tax earnings. However, the IRS will treat it as untaxed earnings so when you start withdrawing from your 401(k), you will pay tax on it again.
Be sure to keep these items in mind when calculating 401k early withdrawal penalties.
Image Credit: InvestorTrip.