The 401(k) Early Withdrawal Penalty: It's Not Fair!

If you are looking for arbitrary and capricious tax results look no further than the 10% "additional tax" on pre-age-59 1/2 distributions from retirement plans. Here are three examples of the maddening inconsistencies that plague this "section 72(t) penalty."

Roll Tuition Payments Through an IRA Jim and Joe are both age 35, both have been working several years at BigCo, both have money in the BigCo 401(k) plan, and both have just quit their jobs to return to school and earn graduate degrees. Each faces a $16,000 tuition bill and needs to tap his 401(k) plan money to pay it.

Jim just requests a $20,000 check from the 401(k) plan, which he deposits in his bank. Minus the 20% income tax withholding, he's left with $16,000 which he uses to pay the school. He figures he'll get the other $4,000 back when he files his income taxes for the year.

In contrast, Joe requests the 401(k) plan to send $16,000 via direct rollover to Joe's IRA; he then withdraws the $16,000 one day later from the IRA and uses it to pay the higher education tuition bill.

The tax code decrees that Jim (but not Joe) must pay a 10% "additional tax" (most people call it a penalty though technically it's just an additional tax) on his $20,000 401(k) withdrawal. Joe does not have to pay a penalty on his $16,000 IRA withdrawal. Reason: There is an exception to the 10% penalty, for distributions matched with expenses of higher education. But that exception applies only to IRA withdrawals; it's not available for 401(k) distributions. By going through the intermediate step of rolling his 401(k) money into an IRA first, then taking the distribution from the IRA to pay the education bill, Joe qualified for the "higher education expenses" exception to the 10% penalty. By taking money directly from the 401(k) plan itself to pay his tuition bill, however, Jim lost out on the higher-education-expense exception.

Incidentally, running the 401(k) money through the IRA also avoids the 20% mandatory income tax withholding otherwise applicable to 401(k) distributions.

We Understand Your Hardship--Sort Of Sally also works at BigCo. She hasn't quit her job, but she is suffering a financial hardship.

Generally a 401(k) plan cannot distribute, to the employee, any money from the employee's "elective deferral" plan account until the employee reaches age 59 1/2 or terminates employment, but there is an exception in cases of hardship: If the employee is experiencing an "immediate and heavy financial need" due to natural disaster, illness, loss of residence, or similar financial catastrophe (all as defined in detail in IRS regulation 1.401(k)-1), the plan can distribute money to defray the expenses.

That makes sense, right? The tax code wisely recognizes that an exception should be made for someone suffering an extreme financial hardship--except that there is no hardship exception to the 10% penalty. So Sally can get her money out of the 401(k) (maybe to rebuild that residence destroyed by a wildfire) but will still owe the government a 10% penalty.

The 'Early Retirement' Illusion The 10% penalty generally applies to distributions taken before age 59 1/2, but one of the dozen or so exceptions is for certain "early retirement" distributions. If you work for a company and you are in the company's qualified retirement plan, and you retire at age 55 (or later), you don't have to pay the penalty on your post-retirement distributions from that plan, even though you haven't quite reached age 59 1/2 yet.

This one comes with its own set of Catch-22 features:

First, you can't retire at age 52, 53, or 54 and then just wait until age 55 and collect penalty-free money from the plan. If you retired before the year you reach age 55 you simply do not qualify for the exception at all.

Second, suppose you retire at 55. You have $1 million in your company plan account. You would like to take annual distributions (penalty-free) of, say, $30,000 from the company plan for a few years until your Social Security kicks in. But the plan tells you, sorry, we only pay lump sum distributions. We'll pay you your whole $1 million right now and you can roll it over to an IRA and take your annual distributions from the IRA. That would be fine, except ...'there is no "early retirement" exception for IRA distributions. So if you take a lump sum distribution from your 401(k) and roll over everything but the $30,000 distribution you want for this current year, all the rest of your money will be trapped in the IRA, with no more "early retirement" exception to help you get your annual income payment.

You're left with some less palatable choices:

You can take the $1 million lump sum distribution and roll over all but five years' worth of the $30,000/year payments you want ($150,000). That way, you'll have enough penalty-free money to tide you over to age 59 1/2. But if you do this, you'll probably be in a higher tax bracket in the distribution year than you normally are.

Or, you can roll everything to the IRA, then set up a "series of substantially equal periodic payments" to pay yourself, from the IRA, the penalty-free income you want to get you to age 59 1/2. That will work, but there are expenses and risks involved in setting up a SOSEPP. So, in theory you have an early retirement exception to the 10 percent penalty--but in reality, sometimes, not so much.

Where to read more: The 10% penalty on pre-age-59 1/2 distributions, and its many exceptions, are explained in detail in Chapter 9 of Natalie Choate's book Life and Death Planning for Retirement Benefits (8th ed. 2019), www.ataxplan.com.

Natalie Choate practices law in Boston with Nutter McClennen & Fish LLP specializing in estate planning for retirement benefits.The views expressed in this article may or may not reflect the views of Morningstar. The electronic version of Natalie's book, Life and Death Planning for Retirement Benefits, is now on a new platform with expanded features. The e-book gives you the entire book in word-searchable format, plus two chapters (on life insurance and annuities in retirement plans). Visit www.retirementbenefitsplanning.net to subscribe or learn more.