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Most of us who have 401(k) plans are told upfront by our plan providers to avoid taking early distributions from our 401(k)s if at all possible.
When I lost my job last year and had unexpected medical needs and fell behind on my house payment and other financial obligations, it seemed like the only option that I had to prevent foreclosure was cashing out my 401(k). Since I wasn’t returning to work I assumed that the value of my 401(k), combined with my unemployment benefits, would be less than my earned income from prior years, so I did not plan for any potential tax consequences. This was a mistake.
Most people are knowledgeable enough about 401(k)s to realize that every dollar that you take out of your plan is a dollar that has lost time that it could have been invested, compounding and growing. What you may not realize is that if you take an early distribution from your 401(k) there is a “special” federal penalty tax of 10% on early distributions. While the investment firm I used held out 10% of the value of my 401(k) for federal income tax purposes, this does not begin to cover the federal tax penalty for the early withdrawal. Also, to make matters worse, if you have taken a loan on your 401(k) and you do not pay it back before leaving your employer, the amount left due on the loan is also counted as a taxable early distribution and is also subject to the 10% penalty.
Each year I have always managed to earn a refund on my federal tax return, but this year I will have to come up with a little over $2,500 by April 17th to avoid additional penalties and interest on my federal tax bill. While my total earned income from the 401(k) distribution and unemployment benefits was less than I usually make each year, the 10% penalty is an unexpectedly significant amount. The entire amount due on my tax bill this year is the 10% penalty for the early distribution from my 401(k).
I cannot stress enough that if you have a 401(k) and you are short of cash that you should try every way possible to avoid taking an early distribution from your plan. If you are like me and you find yourself without a job and you have no other way, then my suggestion is to run the numbers at the time of your distribution and plan for the 10% penalty that will be due at tax time set it aside. Luckily, my state does not also impose a penalty tax for early 401(k) distributions, but not all Americans are so lucky. My suggestion would be to check with your state to discover if there is also a state penalty tax for the early distribution and plan for that as well.
Since I was unaware of this penalty, and I just completed our taxes, I basically have a little less than two months to come up with the $2,500 that is due. A little planning on my part at the time of the early 401(k) distribution last year would have made this a little less financially painful and certainly less stressful.