The federal government encourages you to put some money away for your retirement years, which is why it allows you to defer some of your income tax bill when you contribute part of your salary to a 401k plan. However, these tax savings come with some restrictions that limit your ability to utilize the funds in your 401k account without paying a 10-percent tax penalty.
How 401ks Work
A 401k is an employer-sponsored retirement plan that allows you to defer the payment of tax on the income you use to make contributions to your account. This deferral covers the percentage of each paycheck that you request your employer to deposit directly into your 401k each payroll cycle -- as well as the additional amounts your employer matches or contributes to the account on your behalf. Tax deferral means that your annual contributions are not reported as income on your tax return and aren’t subject to withholding by your employer. Moreover, as the contributions in your 401k earn investment income, you don’t have to report those gains on your tax return either. Instead, you pay income tax on the withdrawals you make during retirement.
The 10-Percent Tax Penalty
The federal government makes the benefit of tax deferral on your 401k account contributions contingent on you not making withdrawals until you reach the retirement age of 59 ½. Generally, if you take money out of your 401k account before reaching this minimum retirement age, not only must you report each withdrawal on your tax return and pay the appropriate income tax, but you must also pay an additional penalty equal to 10 percent of your withdrawals.
Medical & Disability Exceptions
There are a number of exceptions to the requirement that you wait until reaching the age of 59 ½ before taking money out of your 401k that allow you to avoid paying the 10-percent tax penalty. If you become disabled before reaching retirement age, withdrawals you make aren’t subject to the 10-percent penalty. In addition, if you incur a substantial amount of medical expenses and need to make withdrawals from your 401k to pay them, no penalty applies to the amount you are able to report as an itemized deduction — regardless of whether you take the deduction or not. However, since you can only deduct the medical expenses that exceed 7.5 percent of your adjusted gross income, you will pay a penalty on part of your early withdrawals.
Leaving Your Job
You can also take early withdrawals penalty-free if the reason for doing so is because you leave your job. Under these circumstances, the earliest you can leave your job is the year of your 55th birthday. However, if you work as a police officer, firefighter or as an emergency medical professional for a state or local government, your early 401k distributions are penalty-free if you leave your job during or after the year of your 50th birthday.