How To Avoid Paying an Unnecessary 401(k) Penalty

You can be hit with several significant tax penalties if 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), and 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 reach age 59½, making contributions above the amount permitted in a given tax year, and failing to take 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 pay tax on any unrelated business taxable income (UBTI). 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 these 401(k) taxes and costs can result in a significant amount of lost wealth after you factor in the power of compounding, and they should be avoided when at all possible.

Avoiding the 10% Early Withdrawal Penalty

The most common penalty is a 10% early withdrawal tax on money taken out of your 401(k) before you reach age 59½. That penalty is in addition to the standard federal income tax that would come due on the withdrawal, as well as a state levy if you live in a state with an income tax. Some exceptions apply, however.

You may be able to withdraw funds early without paying the penalty for a variety of reasons:

• You're disabled.
• You're paying 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're a military reservist called to active duty.
• You choose to make a series of substantially equal payments.
• You leave your employer during or after the year you reach the age of 55, or the age of 50 if you're a public safety employee of a state, county, or municipality and you participate in a governmental defined benefit plan.

Your beneficiary may also be able to take withdrawals without penalty if you die before age 59½.

Avoiding the Double Tax on Excess 401(k) Contributions

The IRS sets 401(k) contribution limits that determine the maximum amount of money you can put into your account each year. The maximum is $20,500 in 2022, up from $19,500 in 2021, with an additional $6,500 permitted as a catch-up contribution if you're age 50 or older.

You've made what the IRS calls an "excess deferral" if you contribute more than these amounts to your 401(k) in a given year. You must report that amount as taxable income during the current tax year, and you'll still have to pay federal income tax on the funds when you withdraw the money after you retire. You're therefore doubly taxed on contributions that exceed the annual limit.

You can avoid income tax in the current year, however, if you're 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. The removal of the excess money is called a corrective distribution.

Avoiding the 50% Tax for Not Taking RMDs

You're required by law to begin taking money out of your 401(k) each year once you've reached a certain age after retirement. 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 age 70½ if you reached that age before Jan. 1, 2020.

You must then continue taking RMDs by Dec. 31 of each year, starting with the year of your beginning date. You would have to have taken your first RMD by April 1, 2021, an additional RMD by Dec. 31, 2021, and again by Dec. 31, 2022, if you reached age 70½ on July 15, 2020.

The amount you're required to withdraw is calculated by dividing your account balance as of Dec. 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 your RMD.

You must file Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts, along with your Form 1040 tax return if you fail to take an RMD and you must pay a 50% tax on the amount you should have withdrawn.

The IRS might waive the penalty if you failed to take an RMD because of a reasonable error and you're trying to remedy it. You should attach a letter of explanation to your Form 5329.

UBTI Requirements

You might choose to invest in a business structured as a limited partnership or a master limited partnership if you're a high-net-worth investor with a self-directed 401(k). You must file Form 990-T, Exempt Organization Business Income Tax Return, with the IRS if these investments generate unrelated business taxable income (UBTI) of $1,000 or more.

You must pay estimated tax on the income if you expect that your organization will owe more than $500 in taxes in a given year. The top tax rate on UBTI was 37% on an income of more than $13,050 in 2021.

Reducing Fees on Mutual Funds

Most 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. Ideally, you should select funds that charge less than the average for their category: 0.71% for equity funds in 2020 and 0.6% for bond funds.

The percentage for ETFs should be even lower because these funds often seek to passively match the return of a benchmark index. The management expenses should be minimal. The average fee ratio for an index equity ETF was 0.18% in 2020, and for an index bond ETF, it was 0.13%.