The contributions made to a 401(k) account are made of tax deferred dollars. This means that contributions made from the employee’s paycheck are added to the 401(k) account before the pay is taxed. These funds from the account are then invested into various investment vehicles which impart growth to the employee’s money. The funds are taxed only when they are withdrawn from the account. But there are limitations to when an employee can withdraw funds from their account. Overstepping these limitations can result in severe penalties and taxes. Hence, when thinking of a withdrawal from one’s 401(k) account, one must exercise caution. Also the rules for withdrawal vary with the employee’s age and employment status.

Under normal circumstances, all traditional 401(k) plans have a normal withdrawal age limit of 59 ½. When an employee reaches this age, he/she can start withdrawing funds from their 401(k) account. Since the funds and the capital gains from these funds in a 401(k) are tax deferred till a withdrawal is made, the funds withdrawn by the employee after attaining this age, may it be lump sum or distributed, are considered as ordinary earnings and are taxed accordingly.

The provision for the 401(k) plan and its design has been set such that it can provide a stable monetary source (from the employee’s savings) in the employee’s golden years. Hence there are strict federal limitations to discourage employees from withdrawing funds from their 401(k) account before the age of 59 ½. Also, mostly all employers or plan administrators impose severe restrictions on such withdrawals by employees below the age of 59 ½. Should an employee below this age choose to make a withdrawal from the account for any reason, the withdrawal incurs a hefty 10% penalty. Also, according to general rules, the withdrawal will be treated as ordinary income and will be taxed accordingly by the IRS. The general circumstances when an employee is allowed to withdraw from their 401(k) account where they do incur a 10% withdrawal penalty are,

• Funds withdrawn for buying a first home.

• Funds withdrawn to make repairs to the employee’s primary residence.

• And also funds withdrawn to escape eviction from house or to prevent a foreclosure.

• Funds withdrawn for paying for higher education of employee, their spouse, children or dependants (these have certain criteria and limitations).

• Funds withdrawn to pay for medical expenses for self, spouse, children or dependants where such expenses are not reimbursed.

• Withdrawal made for a funeral.

However, there are special circumstances or exceptions when an employee can tap into the funds of their 401(k) account without attracting the 10% tax penalty. These exceptions and their approval may again depend on the rules set by the employer or plan administrator. Some of the general exceptions are as follows.

• Withdrawal or distribution made in case the employee is permanently disabled.

• Funds withdrawn to pay for medical expenses that that are more than 7.5% of the employee’s gross adjusted income.

• When the person rolls over the account into another 401(k) account or an IRA.

• Distributions or withdrawals made to the beneficiary (or beneficiaries) in the event of account holders death.

• Withdrawals made in case of severance from job (example: quitting, termination, permanent layoff or early retirement) at the age of 55 or later.

• Distributed payments arranged by the employee after severance from job. However, once these equal amount disbursement are set-up, they have to be continued till five years or till the employee reaches 59 ½, whichever is longer.

• Withdrawals or distributions made for a qualified domestic relations order; for example a divorce settlement.

An employer or plan administrator may ask the employee to prove the need or essentiality of such withdrawal before the withdrawal is approved. Also, an employee should bear in mind the consequences such withdrawals will have on their future income from the savings in the account because once the withdrawal is made, that money cannot be put back. A 401(k) loan can be an alternative to such withdrawals as it does not attract such penalties and taxes. And also, the funds can be put back in the account by means of extra deductions from the payroll.

Also, with a 401(k) plan there are required minimum distributions where, when the account holder reaches the age of 70 ½ by April 1 of that year, he or she has to start taking the minimum distributions from the account. These distributions are calculated according to the person’s life expectancy. If a person fails to take these distributions or defers them, it attracts a hefty penalty as well. Generally, the penalty is 50% of the stipulated distribution amount.

There are other scenarios as well where a withdrawal can be made from the 401(k) account without incurring penalties. One should refer to their plan documentation or should contact their plan administrator to have a better understanding of these.