401(k) Penalties to Avoid

Don't Get Dinged

401(k) Penalties
••• John Berry, Stock Illustration Source, Getty Images

Whether you invest through a traditional 401(k) plan, a Roth 401(k) plan, or a self-employed 401(k) plan, there are at least two significant penalties that can hit you if you aren't careful in the way you handle the account. Both of these 401(k) penalties can cost you a significant amount of lost wealth once you factor in the power of compounding and should be avoided if at all possible.

10% Early Withdrawal Fee

In exchange for the myriad tax and asset protection benefits offered to investors who take advantage of the 401(k) plan, Congress sets some fairly strict rules on when, and how, you can make withdrawals from your account and has enacted tax penalties for when you break the rules.

The most common of these is a 10% early withdrawal penalty on money taken out of your 401(k) before you turn 59½ years old. The 10% early withdrawal penalty is in addition to any federal, state, and local taxes you would owe on your 401(k) withdrawal, making it possible you could have almost half of your money snatched from you as punishment for raiding your retirement coffers.

There are some exceptions written into the law that you might qualify for. You may be able to withdraw early without penalty if you become disabled, for example, or if you are a military reservist called to active duty. You may also avoid the tax if you can prove you have significant medical debt.

In all cases, be sure to have proper documentation that proves you qualify for a hardship exception.

If you avail yourself of one of these exceptions, you won't have to pay the 10% early withdrawal penalty; you'll just have to pay the ordinary income taxes you would have otherwise owed.

Double Tax on Excess 401(k) Contributions

Congress is very specific when setting the 401(k) contribution limits that determine the maximum amount of money you can put into your account each year. For the 2019 tax year, that maximum is $19,000, with an additional $6,000 permitted as a catch-up contribution if you are 50 or older. For 2020, the maximum is $19,500, with a permitted catch-up contribution of $6,500.

If you exceed the maximum contribution limit, you have made what the Internal Revenue Service calls an "excess deferral." You must include that amount as taxable income during the current tax year, and you will also have to pay federal income tax on it when you withdraw it after you retire.

Overcontributing to a 401(k) results in double taxation of the extra money.

One bright spot: If you are able to remove the excess amount from your retirement account—as well as any amount earned on the excess deferral—before the filing deadline for that tax year, you will avoid the double tax. The removal of the excess money is called a corrective distribution.

Unrelated Business Taxable Income

There is another unusual circumstance that might require you to pay a tax on your 401(k) assets that you wouldn't have to if you treated it as a standard retirement account. Affluent and high net worth investors who have a special type of 401(k) known as a self-directed 401(k) or have transferred their 401(k) into a self-directed Rollover IRA might choose to invest in a master limited partnership or a specially established limited liability company.

For the right investors, under the right circumstances, especially when done by an asset management company that caters to the rich, the complexities that arise from such an investment can be worth it. These complexities can be planned for, mitigated, and factored into the return calculations.

For do-it-yourself investors, it's a much different calculation. They might not be aware that they risk generating something known as unrelated business taxable income (UBTI). If UBTI is in excess of $1,000, investors must pay an excise tax on that amount, starting at 15% up to the first $2,500 and ranging from 15% to 40% above that amount. The investor must also file Form 990-T with the Internal Revenue Service.

The difficulties of investing in these types of companies can still be worth it if an investor's net worth is sufficiently high, but it's not a common practice for average investors. They should consider seeking advice from a trusted retirement planning professional to determine whether such an investment is right for them.

Article Sources

  1. Internal Revenue Service. "Early Withdrawals from Retirement Plans." Accessed March 3, 2020.

  2. Wells Fargo. "401(k) or Other Qualified Employer Sponsored Retirement Plan (QRP) Early Distribution Costs Calculator." Accessed March 3, 2020.

  3. Internal Revenue Service. "Retirement Topics - Exceptions to Tax on Early Distributions." Accessed March 3, 2020.

  4. Internal Revenue Service. "401(k) Contribution Limit Increases to $19,500 for 2020; Catch-up Limit Rises to $6,500." Accessed March 3, 2020.

  5. Internal Revenue Service. "Issue Snapshot - Consequences to a Participant Who Makes Excess Deferrals to a 401(k) Plan." Accessed March 3, 2020.

  6. Fidelity. "Unrelated Business Taxable Income (UBTI)." Accessed March 3, 2020.