Why is there a 10% early withdrawal penalty to cash out a 401k?

Fort Worth Employment Attorney discussing 10% penaltyBefore becoming an employment attorney I worked for one of the largest (maybe the largest) provider of 401k services. We provided various investment, customer service and recordkeeping services for 401k plans. Most people who call for information about their 401k plans will end up talking to my former employer or one of their competitors. Most 401k plan administration responsibilities outsourced to financial institutions that provide the infrastructure and staffing with expertise in plan issues. A common issue for 401k participants is: why is there a 10% early withdrawal penalty to cash out my 401k?

A large number of calls about 401k plans are for withdrawals from the 401k plan. Many people were dismayed to find out that a 10% early withdrawal penalty may apply to their distribution and do not understand why they are penalized for accessing their own money. Today’s post will explain the penalty, why the penalty exists and some options to avoid suffering it.

The taxation basics of ERISA-governed retirement benefits (and some others)

Retirement benefits accrued in an ERISA-governed plan are generally tax-deferred funds taxed upon distribution in which a 10% penalty may apply. ERISA-governed retirement plans include 401k, 403b, most defined benefit plans held by private employers or unions, ESOPs, money purchase pension plans and certain profit sharing plans. Non-government, private employers are likely to have their retirement plans subject to ERISA provisions. Some private employer plans are not ERISA plans although their benefits may be tax-advantaged.

These plans are often not subject to the same tax rules as 401ks and other more common retirement plans. IRAs suffer the 10% early withdrawal penalty with one exception. A special rule applies to SIMPLE IRAs that makes distributions subject to a 25% penalty if distribution occurs within the first two years of participation. Government plans (like 457 plans) are not subject to the 10% penalty except for funds rolled in from a source that is subject to the penalty. The majority of retirement benefits are divisible by a QDRO will be ERISA-governed 401ks, ESOPs and defined benefit pensions in which the following rules apply.

Tax-advantaged deferrals of wages to ERISA plans (401k, 403b, pension plans)

The tax-advantaged status of ERISA plans allows the participant to defer wages and receive contributions from the employer that allows money to go into the plan by deferring some or all of the taxes that would apply in a non-tax-advantaged account. The vast majority of employee deferrals are pre-tax that allows the employee to direct wages into the plan without paying taxes. These funds, as plan rules allow, grow without paying taxes on the gains that accrue.

When the funds exit the plan untaxed, they suffer taxes as ordinary income in the year distributed. That is, unless the funds roll over into another tax-advantaged retirement account or plan. Rollovers continue the tax-deferred status of the funds until the funds are distributed as a taxable distribution to the owner. Employer contributions, no matter the plan type, are always pre-tax and taxed as ordinary income.

After-tax deferrals of wages in ERISA plans

Some plans permit after-tax deferrals from the employee under two different schemes that adjust the taxation of distributions. Under the basic after-tax scheme employees pay taxes on deferrals but the funds go into the plan and grow tax-deferred. The earnings above the deferrals plus employer contributions are all pre-tax. The pre-tax funds are taxable as ordinary income. Deferrals suffer taxation only once.

A newer scheme allows after-tax contributions under the Roth rules. Roth deferrals work like other after-tax contributions (although subject to pre-tax deferral limits) but carry a tax advantage. If deferrals remain for five years and distribution occurs after age 59 1/2 then earnings are tax free. (Any employer contributions made along with the Roth deferrals are still pre-tax.) If a distribution does not meet these rules then the deferrals are after-tax but earnings are taxable.

What is the 10% early withdrawal penalty?

Chapter 26 of the U.S. Code (aka the Internal Revenue Code) section 72 includes various rules that apply to employer-sponsored retirement plans, annuities and life insurance that relate to taxable or potentially-taxable events within those financial products. Among these rules in section 72 is section 72(t) which lays out the 10% early withdrawal penalty that applies to 401k plans and other employer-sponsored retirement plans. Section 72(t)(1) gives us the technical definition of the penalty:

If any taxpayer receives any amount from a qualified retirement plan (as defined in section 4974(c)), the taxpayer’s tax under this chapter for the taxable year in which such amount is received shall be increased by an amount equal to 10 percent of the portion of such amount which is includible in gross income.

How the penalty applies to a distribution

In less technical terms it means you will owe 10% of the full taxable amount of the withdrawal as an additional tax (penalty) in addition to any ordinary income tax already due for the withdrawal. For example, if you take out $10,000 and the full $10,000 will be taxable to you as income then you would expect to owe ordinary income tax on the full $10,000 plus an additional $1,000 as the 72(t) penalty. Sometimes people do not realize that the mandatory (and any optional) withholding for taxes at the time of distribution is part of the taxable distribution itself and you owe both taxes and penalty on that portion as well.

Generally this penalty applies to withdrawals before the participant reaches age 59 1/2 although there are several exceptions to the penalty that may apply earlier. The penalty never applies over the age of 59 1/2.

Why is there a 10% early withdrawal penalty?

The early withdrawal penalty deters people from burning through retirement savings before retirement. 401k plans and other retirement plans incentivize retirement saving by creating tax advantages that otherwise would not apply. These include deferring taxes on your contributions, allowing tax-deferred growth and Roth rules that result in tax-free earnings. In exchange Congress created a system encouraging retirement saving and discouraging depleting retirement savings prematurely. The exchange for getting the tax benefits in the 401k is committing yourself to saving that money for retirement.

It’s understandable that people don’t want to pay a penalty on their own money. (I don’t make the rules–I am just explaining them.) However we have a growing problem with people reaching retirement age unable to financially support themselves due to rising cost of basic needs and the declining retirement income opportunities.

How can I avoid 10 penalty on 401k withdrawal?

There are a number of exceptions to the 10% penalty that may apply to a distribution. Let’s work through those.

First, not all distributions are fully or partially taxable distributions. Any distribution or any portion of a distribution that is not taxable as income is not subject to the penalty. This generally includes three types of distributions. (1) Any distribution that constitutes a qualified rollover from the 401k plan to another eligible tax-deferred account (like an IRA or another 401k plan) is not taxable at the time of the rollover so no penalty applies to the rollover. (2) Any portion of after-tax funds in the 401k is not subject to the 10% penalty because after-tax funds are not taxed again in the withdrawal. Any pre-tax funds distributed at the same time suffer taxes and penalties if the penalty otherwise applies. (3) Roth funds suffer penalty to the extent the funds suffer taxation.

Roth deferrals and 10% withdrawal penalty

Roth deferrals by the employee are after-tax so they are not subject to the penalty. Earnings on Roth deferrals are not taxable if the earnings meet the qualifications to come out tax-free. (The withdrawal is after age 59 1/2 and at least five years after the first Roth deferral). If the earnings do not qualify as tax-free under Roth rules then they are taxable.

The complication here is that a withdrawal may have multiple tax statuses. Few people have after-tax deferrals that are not Roth deferrals but an increasing number of people are making Roth contributions. As a result those people will have after-tax money in their 401k plan. There is likely pre-tax funds that will suffer taxes and possibly penalties. These include Roth earnings not part of a qualified distribution and employer contributions (like company match) that are never after-tax. It is important to understand what portions of a withdrawal are taxable to determine your overall tax liability on the withdrawal.

10% withdrawal penalty exceptions for cashing out 401k and other ERISA plans

There are a number of exceptions under 72(t) that avoids the 10% penalty. Some exceptions are simple while others are more complicated and reference multiple other tax code sections. I will just describe the exceptions generally. Their application is technical and you should understand the specifics of each exception that may apply while considering a distribution.

  1. The distribution is made on or after the date on which the participant attains the age 59 1/2. At this point the distribution is no longer “early” so the penalty does not apply.
  2. The distribution is made to a beneficiary on or after the death of the participant.
  3. Distribution is attributable to the employee’s disability (as specifically identified).
  4. The distribution is part of a series of substantially equal periodic payments made at least annually for the life of the employee.
  5. Distribution occurs after the participant leaves work with the company providing the 401k on or after the date the participant reaches age 55.
  6. The distribution is dividends paid from a qualified stock ownership plan.
  7. Distribution is the result of a tax levy by the IRS.
  8. The participant has deductible medical expenses claimed on a federal income tax return in the year of the distribution to the extent of the deduction.
  9. The distribution is made subject to a QDRO or child support lien for child support, spousal support, or division of property in a divorce.
  10. The distribution qualifies as a qualified reservist distribution for reservists in the armed forces.

Some of these exceptions will completely avoid the penalty, including age-based exceptions and total and permanent disability. However, other exceptions like the medical expenses exception will only avoid the penalty to the extent the exception applies. You may owe the penalty on some of the taxable amount of the distribution.

(Under the CARES Act, special covid-related withdrawals are available.)

QDROs in divorces and 10% early withdrawal penalty

QDROs are a powerful tool in the property division in a Dallas or Fort Worth divorce. They allow a party to receive part of an employee’s retirement plan benefits (such as a 401k or defined benefit pension). Under the federal law that governs private retirement plans (ERISA) an employer generally may not take away or give part of an employee’s accrued benefit to another person. (This is known as ERISA’s anti-cutback rule.)

The exception is for a qualified domestic relations order (QDRO) that awards a portion of the employee’s benefit to a spouse, former spouse, child or other dependent of the plan participant. A QDRO divides the employee’s benefit and gives it to the alternate payee without creating a taxable distribution for the employee. The share received by the alternate payee is taxable to the alternate payee. The question often arises whether the alternate payee must also pay the 10% early withdrawal penalty for taking funds out of the 401k or other retirement plan. 

The benefit of QDRO to avoid the 10% withdrawal penalty

Retirement funds obtained through a QDRO do not incur a 10% early withdrawal penalty so long as the funds are paid as a taxable distribution from the plan in which the QDRO applies directly to the alternate payee. (Internal Revenue Code section 72(t)(2)(C) ) This rule is barely known even among financial advisers and divorce attorneys, who frequently deal with QDROs and QDRO funds. In my pre-attorney days working at a major retirement plan service provider, we frequently fielded calls from financial advisers who were clueless about this exception. Many times they were mad because the alternate payee had talked to our service associates and learned about the exception. The advisers were mad.

When QDROs do not prevent the 10% withdrawal penalty

Here’s why it made them angry. The exception only applies on a taxable distribution from the plan in which the QDRO applies. If the money rolls over then the penalty will apply to any future taxable distribution. (Unless some other exception applies.) The advisers want to roll over that money into an IRA because to get paid. (Many advisers make their money taking a cut of assets brought in.) Reinstating a penalty that otherwise would not exist is not in the best interests of the client. The adviser likely should not recommend the rollover if the alternate payee might need those funds before age 59 1/2.

The alternate payee does not pay the 10% early withdrawal penalty if the alternate payee cashes out after the divorce. The bad news is that it’s still taxable as ordinary income to the alternate payee. If the sum is substantial it could have the effect of creating an unexpectedly large tax bill for the year. Cashing out and the tax consequences are among the reasons the divorce should contemplate financial needs and goals.

 

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