Obama's Broken Promise? 401(k) Penalties Persist

Feb. 24, 2009 — -- In these tough times, it's natural that many individuals are looking to their retirement savings as a source to meet pressing needs.

A 401(k) plan or similar retirement account is the single largest asset that many Americans have, after their home. It seems like the best place to turn in times of financial hardship, but be aware that such a move comes at a cost.

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IRS rules about tapping a 401(k) account before retirement are strict and provide limited exceptions to allow you to gain early access to your money. Even if you qualify for an exception, there's a good chance you will still be subject to a penalty on top of the usual income taxes.

The question below comes from a reader who wonders whether she might be able to tap into her 401(k) account to meet current needs.

Q: I thought I read somewhere that if you were laid off and had to withdraw from your 401(k), the government would not fine you the extra 10 percent for early withdrawal. But when I went to my accountant to do my taxes, he was not aware of this. Is it true or not?

-- M.H., Southfield, Mich.

A: M.H., your accountant is correct. There currently is no provision to allow you to withdraw 401(k) funds early without penalty in the event of a layoff.

Late in the 2008 campaign, President Obama proposed allowing penalty-free withdrawals of up to $10,000 from 401(k) accounts and other retirement savings plans in response to the current recession.

Thus far, this is one campaign promise that has gone nowhere. There was no such provision in the recently enacted economic stimulus plan.

In most cases, a hardship withdrawal from a 401(k) or other retirement savings account before age 59½ will still trigger a 10 percent penalty plus federal, state and local income taxes.

Take a $10,000 early withdrawal from a retirement plan, and you could easily lose 40 percent to taxes and penalties, depending upon your tax bracket and where you live. That's why an early withdrawal should be an absolute last resort.