How to Avoid IRS Tax Penalties for a 401(k) Early Withdrawal

Normally you can't tap your retirement plan -- whether it's a 401(k) or IRA -- before you turn 59 1/2. Withdrawing the money early is costly. You'll pay not only regular income tax on the money, but a 10 percent penalty on top of that. For a $5,000 withdrawal, for instance, the penalty would be $500. However, federal tax law does allow the Internal Revenue Service to waive the penalty in certain cases.

If your company's plan allows it, you can withdraw money when faced with financial hardship. This doesn't exempt you from the 10 percent penalty, except when the hardship is high medical bills. To qualify, bills have to be at least 10 percent of your adjusted gross income after subtracting for any insurance or other reimbursement. To access the funds penalty-free, you'll have to show your employer that you have no other source for the money.

If you've already left your employer, you can avoid the penalty by making not one withdrawal but several -- substantially equal period payments, in IRS-speak. You have to take withdrawals for a minimum of five years, or until you turn 59 1/2, even if that adds up to more than you want to withdraw. If you stop withdrawing money before the cut-off points, the IRS can impose the 10 percent penalty.

The IRS gives you three options for figuring how big your periodic payments should be. One is to calculate your withdrawal based on the length of your life -- based on IRS tables -- and the size of the account. The other two methods factor in the interest on your account as well. Payments may vary year-to-year under the first method, but the other two deliver a fixed result. To avoid penalties you have to withdraw the amount the formula requires, no more, no less.

If you leave your job after you turn 55, you can withdraw the money without taking periodic payments. This works just as if you reached 59 1/2 -- you can withdraw any amount you want, though you have to pay the usual income tax. Talk to the plan administrator first, as the plan may have restrictions you have to meet. The administrator can also explain the IRS requirements. You can't, for example, roll the withdrawal over into an IRA.