Early withdrawal penalty (10% additional tax)

What the early withdrawal penalty is

The tax applies to the taxable part of a distribution. For 401(k) plans the exceptions include leaving the employer in or after the year you turn 55, death, disability, payments under a QDRO, a series of substantially equal payments, medical expenses above 7.5% of adjusted gross income, up to $5,000 for a birth or adoption, and up to $1,000 a year for an emergency personal expense. Some exceptions, such as a first home purchase, apply only to IRAs.

Why it matters to employers

The plan does not charge the penalty. The participant reports it on their tax return, and the plan reports the distribution on Form 1099-R. What the plan does withhold is 20% federal income tax on any payment that could have been rolled over, and employees often mistake that withholding for the penalty. Explaining the difference when someone leaves helps them choose a rollover.

Example

A 35-year-old leaves her job and cashes out $10,000. The plan withholds $2,000. At tax time she owes income tax on the full $10,000 plus a $1,000 additional tax. A direct rollover to an IRA or a new employer’s plan would have avoided both.

Common mistakes

• Telling employees the 20% withholding covers the penalty.

• Assuming a hardship withdrawal is exempt. Hardship alone is not an exception.

• Applying IRA-only exceptions to a 401(k).

• Applying the age 55 exception to a plan from an earlier job. It covers only the plan of the employer the person left at 55 or later.