How to Avoid 401(k) Fees and Penalties

Saving in a 401(k) often gets you tax breaks and employer contributions. However, in order to keep that money, you need to steer clear of 401(k) penalties. Here are some common 401(k) transactions that trigger fees and taxes, plus how you can avoid them.

Early withdrawals. If you withdraw money from your 401(k) account before age 59 1/2, you will need to pay a 10 percent early withdrawal penalty, in addition to income tax, on the distribution. For someone in the 25 percent tax bracket, a $5,000 early 401(k) withdrawal will cost $1,750 in taxes and penalties. There are a couple of exceptions to the 401(k) early withdrawal penalty. If you lose or leave your job at age 55 or later, you won’t have to pay the 10 percent penalty on withdrawals from the 401(k) associated with the job you most recently left. “In almost all cases you really want to avoid taking money out early because that’s a detriment to your future self,” says Mary Erl, a certified financial planner for Nest Builder Financial Advisors in Gurnee, Illinois. “The best way to avoid an early withdrawal is to have an emergency fund.”

Incorrectly rolling over your 401(k). When rolling your 401(k) balance over to an IRA or another 401(k), it’s important to transfer the money directly from your 401(k) to the custodian of the new account. “When you are doing a rollover to an IRA, do a trustee-to-trustee transfer so the 401(k) plan administrator will make that check payable to where that IRA is custodied,” says Maureen Poplaski, a certified financial planner for Lighthouse Financial Management in Westerly, Rhode Island. If the check is made out to you, 20 percent with be withheld for income tax. If you don’t put the entire amount, including the withheld 20 percent, into a new retirement account within 60 days, any portion not rolled over is considered a distribution, and income tax and the early withdrawal penalty may apply.

Leaving a job before you are vested in the 401(k) plan. While you always get to keep your personal contributions to a 401(k) plan, you can’t keep your employer’s contributions until you are vested in the 401(k) plan. While some companies provide immediate vesting for the 401(k) match, others require as long as two or three years of service before you are eligible to keep any of the match if you leave the firm. Some employers allow you to keep a percentage of the 401(k) match that depends on your years of service, but you might not get to keep all of it unless you stay with the company for five or six years. ” Consider what you’re giving up if you decide there is an employment opportunity that will in the long run be better off for you,” Poplaski says. “But also look at the opportunity cost of staying there.”

Selecting expensive funds. If the expense ratio of any of the funds in your 401(k) is over 1 percent, you’re probably paying too much. Take a look at your annual 401(k) fee disclosure statement, which lists how much it costs to invest in every fund in the plan. “You have to focus on the fund fees because those you can actually change by making different choices,” says Quinn Curtis, a professor at the University of Virginia School of Law. “The vast majority of plans are going to include index fund options, and the evidence suggests that it’s hard to go wrong with an index fund.” Switching to a lower cost fund will reduce your investment costs and help your 401(k) balance to grow faster.

Taking a 401(k) loan. While typically less damaging than an early withdrawal, 401(k) loans charge a variety of fees. Most 401(k) loans have administration, maintenance and origination fees. Plus, if you leave your job, the loan becomes due. Loans that are not paid back within five years or upon leaving your job can trigger income tax and the early withdrawal penalty. “When you take a loan you might think you are paying yourself back, but you are missing out on the compounding while the money is out,” Erl says. “And when you are repaying the loan you are paying with money that has already been taxed, and when you take the money out of the 401(k) it is taxed again, so you are getting taxed twice.” If you need to borrow money, compare the terms of the 401(k) loan to other types of loans you might be eligible for.

Missing required minimum distributions. 401(k) withdrawals are required after age 70 1/2, unless you are still working for a company you don’t have an ownership stake in. The penalty for missing a required minimum distribution is 50 percent of the amount that should have been withdrawn in addition to the regular income tax you owe on the distribution. For someone in the 25 percent tax bracket, skipping a $5,000 401(k) distribution would trigger $3,750 in taxes and penalties.

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