How to Avoid Paying an Unnecessary 401(k) Penalty
Don't get dinged
Whether you invest through a traditional 401(k) plan, a Roth 401(k) plan, a self-employed 401(k) plan, or a self-directed 401(k), there are several significant tax penalties that can hit you if you aren't careful in the way you handle the account. The most common reasons for being penalized are withdrawing money from your retirement account before you turn 59½, making contributions above the amount permitted in a given tax year, and failing to make annual withdrawals from your account after you reach the age of 70½ or 72, depending on when you were born.
You can also expect to be taxed on any unrelated business taxable income (UBTI) earned from certain holdings in a self-directed 401(k). And you risk losing retirement income through fees if you invest in funds that charge a high percentage of your account balance to manage your money.
All of these 401(k) taxes and costs can result in 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 Tax
The most common of the penalties is a 10% early withdrawal tax on money taken out of your 401(k) before you turn 59½ years old. That penalty is in addition to the standard federal income tax that would be withheld, as well as the state levy if you live in a state with an income tax.
There are some exceptions to the penalty that you might qualify for, including one related to COVID-19 that was enacted by the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) in March 2020. You can withdraw up to $100,000 from a 401(k)—or a 403(b) or individual retirement account (IRA)—without penalty if you meet the law's criteria.
- You, your spouse, or a dependent is diagnosed with the virus SARS-CoV-2 or with the COVID-19 disease by a test approved by the Centers for Disease Control and Prevention.
- You experience adverse financial consequences as a result of being quarantined, furloughed, or laid off or having your work hours reduced due to SARS-CoV-2 or COVID-19; or as a result of being unable to work due to lack of child care due to SARS-CoV-2 or COVID-19; or as a result of closing or reducing the hours of a business that you own or operate due to SARS-CoV-2 or COVID-19.
As of September 24, 2020, such a distribution could be made without penalty through December 30, 2020.
You also may be able to withdraw funds early without paying the 10% penalty for a variety of other reasons.
- You are disabled.
- You are paying alimony or child support or levies owed to the Internal Revenue Service (IRS).
- You have unreimbursed medical expenses amounting to at least 7.5% of your adjusted gross income.
- You are a military reservist called to active duty.
- You choose to make a series of substantially equal payments to yourself.
- You leave your employer during or after the year you reach the age of 55 or the age of 50 if you are a public safety employee of a state, county, or municipality and participate in a governmental defined benefit plan.
Your beneficiary may also be able to make withdrawals without penalty if you die before the age of 59½.
In all cases, be sure to have proper documentation that proves you qualify for the exception.
Double Tax on Excess 401(k) Contributions
Every year, the IRS sets 401(k) contribution limits that determine the maximum amount of money you can put into your account each year. For the 2020 tax year, the maximum is $19,500, with an additional $6,500 permitted as a catch-up contribution if you are 50 or older.
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 those funds when you withdraw it after you retire. That means you're ultimately doubly taxed on contributions that exceed the annual limit.
One important qualification: 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 the tax year in question, you will avoid the double tax. The removal of the excess money is called a corrective distribution.
50% Tax for Failing to Take Required Minimum Distributions
Once you have reached a certain age after retirement, you are required by law to begin taking money out of your 401(k) every year. The first required minimum distribution (RMD) must be taken by April 1 of the year after the year in which you reach the age of 72 or the age of 70½ if you reached that age before January 1, 2020.
You must then continue taking an RMD by December 31 of each year, starting with the year of your beginning date. For example, if you turned 70½ on July 15, 2019, you would have needed to take your first RMD by April 1, 2020, and you will need to take an additional RMD by December 31, 2020 and again by December 31, 2021, and so on.
RMDs are required for just about every type of retirement account, including 403(b) and 457(b) plans, IRAs, and Roth 401(k)s. However, they are not required for Roth IRAs while the owner is alive.
The amount you are required to withdraw is calculated by dividing your account balance as of December 31 of the prior year by a factor based on your life expectancy. Appendix B of Publication 590-B, Distributions from Individual Retirement Arrangements (IRAs) provides tables of life expectancy factors that apply to 401(k)s. Your retirement plan administrator may also be able to tell you what your RMD is.
If you have more than one 401(k) account, you must take the RMD from each of them. If you have multiple IRAs, you may take the total RMD for all of the IRAs from one account or in pieces from multiple accounts.
If you fail to take an RMD, you must pay a 50% tax on the amount you should have withdrawn and you will have to file Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts along with your Form 1040.
You may be able to have the penalty waived by the IRS if you failed to make an RMD because of a reasonable error and are trying to remedy it. You should attach a letter of explanation to your Form 5329.
The CARES Act permits the owner of a retirement plan to skip the RMD for 2020. If a retiree had already taken an RMD before the CARES Act went into law, they could have rolled the money back into the account before August 31, 2020.
Generating Unrelated Business Taxable Income
If you are high-net-worth investor with a self-directed 401(k), you might choose to invest in a business structured as a limited partnership or a master limited partnership. If these investments generate UBTI of $1,000 or more, you must pay an excise tax on that income.
The unrelated business income tax (UBIT) can be as high as 37%, depending on income bracket, with the highest rate applying to income of more than $12,750. If you owe UBIT, you must also file Form 990-T, Exempt Organization Business Income Tax Return with the Internal Revenue Service.
High Fees on Mutual Funds
Most people's 401(k) money is invested in mutual funds, with some plans also offering exchange-traded fund (ETF) options. Paying high management fees on your investments can significantly cut into your returns over decades of investing.
Actively managed funds take a portion of investors' assets to pay for the people who select the investments that go into them. You should ideally select funds that charge less than the average for their category: 0.52% for equity funds in 2019 and 0.48% for bond funds.
For ETFs, the percentage should be even lower because these funds often seek to passively match the return of a benchmark index, so the management expenses should be minimal. The average fee ratio for an index equity ETF was 0.18% in 2019, and for an index bond ETF, it was 0.14%.
Internal Revenue Service. "Coronavirus-Related Relief for Retirement Plans and IRAs: Questions and Answers." Accessed Sept. 24, 2020.
Internal Revenue Service. "Retirement Topics — Exceptions to Tax on Early Distributions." Accessed Sept. 24, 2020.
Internal Revenue Service. "401(k) Contribution Limit Increases to $19,500 for 2020; Catch-up Limit Rises to $6,500." Accessed Sept. 24, 2020.
Internal Revenue Service. "Issue Snapshot — Consequences to a Participant Who Makes Excess Deferrals to a 401(k) Plan." Accessed Sept. 24, 2020.
Internal Revenue Service. "RMD Comparison Chart (IRAs vs. Defined Contribution Plans)." Accessed Sept. 24, 2020.
Internal Revenue Service. "Retirement Plan and IRA Required Minimum Distributions FAQs." Accessed Sept. 24, 2020.
Internal Revenue Service. "IRS Announces Rollover Relief for Required Minimum Distributions From Retirement Accounts That Were Waived Under the CARES Act." Accessed Sept. 24, 2020.
iPlanGroup. "How to Calculate Unrelated Business Income Tax (UBIT)." Accessed Sept. 24, 2020.
Investment Company Institute. "ICI Research Perspective: Trends in the Expenses and Fees of Funds, 2019," Page 1. Accessed Sept. 24, 2020.
Investment Company Institute. "ICI Research Perspective: Trends in the Expenses and Fees of Funds, 2019," Page 2. Accessed Sept. 24, 2020.