A 401(k) can win even after the 10% penalty.

The rule

Money that you take from a 401(k) or a traditional IRA before age 59½ is an early distribution. Income tax applies to most distributions. An early distribution also has an additional 10% tax, unless an exception applies. This page calls this additional tax the penalty.

The comparison

We compare two ways to save $10,000 of pay. In the first way, you put all $10,000 in a 401(k). You pay no income tax on it now. In the second way, you pay tax at an assumed 22%. Then you put the $7,800 that is left in a taxable account.

Both accounts grow 7% a year. In the taxable account, 2% of the return comes as dividends. You pay an assumed 15% on the dividends each year, and on the gain when you sell. When you take money from the 401(k), you pay your income tax rate in that year plus the 10% penalty.

Case 1: your tax rate stays the same

On day one, the penalty costs $1,000. The 401(k) gives you $6,800 after tax and penalty. The taxable account gives you $7,800. So the 401(k) starts 12.8% behind.

The gap gets smaller each year. At our assumptions, the 401(k) moves ahead in year 20.

Here is the reason. Compare each account with a third account that pays no tax on its growth. That account holds the $7,800 that is left after income tax, and it grows 7% a year.

At equal rates, the 401(k) is always 12.8% below that account. The income tax leaves you 78% of the balance, and the penalty takes 10 more points. That is 12.8% of what the income tax leaves you.

The taxable account is also below that account, because it pays tax on its growth. At first, there is little growth, so the tax is small. As the growth becomes a larger part of the balance, the taxable account falls further below. After 15 years, it is 10.8% below. After 20 years, it is 13.2% below, which is more than 12.8%.

Case 2: your tax rate is lower when you take the money

Some people take money early because they stop work early. Their income in that year can be low. Suppose that your rate is then 12%, not 22%. The 12% tax plus the 10% penalty is 22%. That is the same rate that you did not pay when you put the money in.

We give the taxable account the same low income. At a low income, long-term gains can have a 0% rate. For 2025, the IRS gives that rate to single filers with taxable income up to $48,350. We assume that the gain fits under that limit. Thus the taxable account pays no tax on its gain at the sale.

The two accounts are equal on day one. After that, the 401(k) is always ahead, because it pays no tax on dividends while you hold it. After 20 years, it is 5.8% ahead.

Case 3: your employer adds a match

Some employers add money when you contribute. Suppose that your employer adds 50 cents for each dollar. Your rate stays at 22%.

Only the vested part of a match is yours. Your own contributions are always fully vested. A plan can make you wait before the match is fully yours. If you leave before that, you can lose the part that is not vested.

Routes with no penalty

The IRS lists many exceptions to the 10% tax. Two of them are important for people who stop work early.

Separation from service at age 55. You leave your job during or after the year that you turn 55. The IRS lists this exception for qualified plans, such as a 401(k). For some public safety employees, the age is 50. The exception does not apply to an IRA.

Substantially equal payments. You take a series of substantially equal payments. The IRS lists this exception for qualified plans and for IRAs. Section 72(t) of the tax code sets the rules for these payments. The rules are strict, so read them before you start.

When the taxable account is better

The taxable account wins if three things are all true. You will need the money soon. Your tax rate will not decrease. You get no match. In our example, the 401(k) is then behind until year 20.

A higher tax rate later makes the 401(k) worse. Each extra point of tax takes money from the 401(k), and the break-even year comes later.

What to do

Take the full match first. In our example, it is larger than the penalty on day one.

Estimate your tax rate in the year that you will take the money. If that rate is 10 points lower than your rate now, the penalty costs you nothing on day one.

Keep money for the next few years outside the 401(k). At equal rates, the penalty is larger than the tax break for many years.

Learn the exceptions before you need them. The age-55 rule applies only to a plan, not to an IRA. Think about this before you move a 401(k) to an IRA.

What this leaves out

The model does not include state tax or fees. It uses one fixed rate of return, with no bad years. It does not include Roth accounts or hardship distributions. It also does not include a 401(k) loan. Our essay on the 401(k) loan covers that option.

Sources

• IRS, Retirement topics: tax on early distributions, for the additional 10% tax before age 59½.
• IRS, Retirement topics: exceptions to tax on early distributions, for the separation from service at age 55 or 50 and for substantially equal payments.
• IRS, Retirement topics: vesting, for the ownership of your own contributions and of employer contributions.
• IRS Topic No. 409, Capital gains and losses, for the 0% rate on long-term gains in 2025.