401k Investors Whacked With Big Penalty

Risks of Taking Out Your Investments

If you are just nervous about the market and want to get out of stocks, every retirement plan offers relatively safe investments such as money market accounts. Moving money into those funds doesn't trigger any penalties, said Dean Kohmann, vice president of 401(k) Plan Services at Charles Schwab.

"People do make that mistake of trying to time the market by simply stepping out of the market," Kohmann said. "Retirement money is long-term money. If you're in your 30s, or 40s, or early 50s, you have a lot of years."

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In the short term, withdrawing money from a 401(k) account before age 59 ½ -- known as a "hardship withdrawal" -- can open an investor up to steep penalties: Investors must pay a 10 percent federal penalty tax on the money they withdraw and must also have that money subject to income tax. For instance, if a person in the 25 percent tax bracket withdraws $50,000 from their 401(k) account, he or she will ultimately pay $17,500 in taxes on the withdrawal.

An investor willing to swallow the tax hit still must face significant hurdles before withdrawing money. Linda Wolohan of Vanguard said that, under rules set by the Internal Revenue Service, those who withdraw money early must exhaust other sources of funding before turning to their 401(k)s. Then, she said, they must prove that they need the money for one of five reasons: the purchase of a home or home repairs; medical bills; educational costs; funeral expenses; or warding off foreclosure or eviction.

These obstacles notwithstanding, T. Rowe Price has seen a 14 percent increase in hardship withdrawals in 2008. Fidelity Investments, the largest provider of retirement plans, saw a 7 percent increase in hardship withdrawals from April through June of this year.

Not everyone who has recently taken a withdrawal may have been aware of the tax penalties involved.

Massachusetts Secretary of the Commonwealth William Galvin is trying to temporarily suspend the 10 percent penalty for investors who sold in a panic.