401(k) Early Distribution Tax Penalty

If I withdraw my 401(k) and give it to my spouse as a gift, would I still face a very steep tax penalty?

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Bill's Answer: Answered by Daniel Cohen

Congress and the IRS call withdrawals from a 401(k) or other qualified retirement plan a distribution. In general, if you take a distribution from a traditional individual retirement account such as a 401(k) or other qualified retirement plan before you turn age 59½, you are subject to a 10% penalty tax. The taxable amount is added to your taxable income. Put another way, the 10% penalty tax is in addition to your regular income taxes. Please note that the associated penalties and taxes are applied at the time of your withdrawal transaction, so even if you plan to gift the proceeds later on, you will still be liable for the penalties and applicable taxes.

All 401(k) Distributions Are Subject to Income Tax

You can avoid this additional tax penalty if you meet certain criteria, but you cannot avoid including your retirement withdrawal from your taxable income. Some distributions can be made without penalty, but these usually require a financial hardship. I will provide more information about 401(k) hardship-based distributions in a moment.

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Here is more information about hardship-based distributions.

Hardship Withdrawals

Hardship withdrawals, called "distributions," are permitted from 401(k) plans. They are subject to applicable income taxes and a 10% early withdrawal penalty if you are younger than 59½.

Financial hardship withdrawals are allowed for the following reasons:

  • To buy a primary residence
  • To prevent foreclosure or eviction from your home
  • To pay college tuition for yourself or a dependent, provided the tuition is due within the next 12 months
  • To pay un-reimbursed medical expenses for you or your dependents
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Early Withdrawal Penalty Exceptions

You may qualify to take a penalty-free withdrawal, but are still subject to income taxes,  if you meet one of the following exceptions, consistent with Section 72(t) of the Internal Revenue Code:

  • You become totally disabled.
  • You are in debt for medical expenses that exceed 7.5% of your adjusted gross income.
  • You are required by court order to give the money to your divorced spouse, a child, or a dependent.
  • You are separated from service (through permanent layoff, termination, quitting or taking early retirement) in the year you turn 55, or later.
  • You are separated from service and you have set up a payment schedule to withdraw money in substantially equal amounts over the course of your life expectancy. (Once you begin taking this kind of distribution you are required to continue for five years or until you reach age 59½, whichever is longer).

See the IRS documents 401(k) Resource Guide - Plan Participants - General Distribution Rules and Publication 575 (PDF) to learn more about 401(k) distribution rules.

Consult With a Tax Professional

Speak with both the 401(k) plan administrator and a tax professional to make certain that you understand your total tax obligations. I have seen many people who thought they had accounted for all taxes owed, only to find out that they owed a lot more, once the return was prepared. For instance, a large 401(k)withdrawal can raise the total income for the year to the point where the taxpayer falls into a higher income tax bracket. When that happens, the amount that the taxpayer was having withheld from his or her regular paychecks may prove to be insufficient to cover the tax obligation at the new, higher tax rate.

Even worse, if a person files an incorrect return, understating the taxes owed, it may take years for the IRS to catch the error. Once the IRS does correct the error, it is the taxpayer who will owe the taxes plus years of interest and penalties.

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Comments (303)

Sam H.
Park City, IL  |  April 13, 2014
I see some great discussions happening here! I too have a query. I am a green card holder and planning to return to India in 5-6 years. If I withdraw my IRA early when I am in India, I understand I will be penalized with 10% penalty. As per the rule, there is a tax exemption of around $97,000 when you are working in a non resident country. Si, I understand that when I start working in India after 5-6 years, I will be tax exempted till 97,000 of my salary. Question: 1. How will the early IRA withdrawl come into play as far as my taxation is concerned? In India, my salary will be only around $60,000. So if I withdraw, lets say, $10k early apart from the 10% penalty would there be any tax implication? Thanks for your help Sam
April 15, 2014
Sam, you ask a tough question, one that you will likely need professional assistance with. I will share my opinion, but consult with a tax professional before you decide what steps to take.

Generally, the foreign earned income exclusion (FEIE) only exempts foreign earned income. IRA distributions do not count as "earned income" for FEIE purposes even though they are essentially delayed earnings. Further, the distributions here are U.S.-source rather than foreign. So the distribution amount will be taxed as ordinary income (less standard/itemized deduction and any personal exemption).

You might look into 72(t) distributions to see if that appeals to you, but you would be stuck with the annuitized payments. It would avoid the 10% penalty and the resulting U.S.-source income (absent any other facts) would likely be low enough that you wouldn’t owe. The U.S.-India tax treaty may change how the distribution is taxed and by whom, but that’s definitely a pay for research kind of thing.
Rob P.
Staten Island, NY  |  March 25, 2014
Both my wife and I were recently laid off. I am 56 1/2, she is 50. We have no choice but to withdraw from our IRA to save our home and pay our monthly bills. Can we claim these withdrawals as hardship? If not, we will no options and will lose our home, cars and have no money for food, insurance, etc.
March 26, 2014
Some hardship withdrawals, though permitted, still have a 10% penalty for early withdrawal and some do not. I advise you to meet with a tax specialist. If you were separated from your service after age 55, which appears to be the case, then different rules apply to money withdrawn from your account and from your wife's. I believe that your withdrawal would be penalty free, but hers would not.

Discuss with the tax professional the penalty-free age 55 exemption as well as the exemption for avoiding foreclosure that comes with a 10% penalty.
Salem, NH  |  March 25, 2014
My wife and I purchased a home in 2013 and when I read the requirements for withdrawals out of a IRA for first time home buyer I did not see anything indicating I needed to withdraw 10k from MY IRA and another 10k from HER IRA in order to no pay a penalty. I instead withdrew all 20k from my IRA and not I'm wondering how I can fix this if issue, if at all? We're married so I didn't think it made a difference whether I withdrew from one or both since I felt like my IRA is actually ours. Thank you!
March 25, 2014
I am unaware of any requirement in the distribution rules requiring distributions from spouses' IRAs to be identical to avoid a penalty tax. Please share the source of your information on this requirement. If it was an IRS publication, please share its name in a comment below.
Salem, NH  |  March 25, 2014
I'm sorry, I wasn't clear. I wanted to take 20k for closing cost and instead of taking 10k from my IRA and 10k from my wifes IRA I withdrew the entire amount from my IRA, 20k. When I read the requirements I did not see anything that required the withdrawals to be from separate accounts. When I was thinking about it I assumed I could withdraw the entire 20k from my IRA and still be able to claim the penalty exemption since both my wife and I are first time home buyers. Now that I'm doing my taxes it would appear I needed to split the withdrawals into two separate transactions, 10k withdrawal from my IRA account and 10k withdrawal from my wife's IRA. Am I reading this correctly or is it just the limitations of the online tax software?
March 27, 2014
It would appear you encountered a limitation in the software, or perhaps there's more going on with your return that I lack the imagination to fathom. Your best bet is to consult with the software maker, and then a tax preparation person who can review your return in person.
Luke G.
West Warwick, NH  |  March 24, 2014
Hi, my wife and I have 9k on her 401k. we are 32 years old and have 3 children. we make about 62k annual and file jointly. we want to do an early withdrawal. We want to use 3k to pay off one debt to fix our credit, and the rest for a down payment because we are in the process of getting pre-approved for a mortgage. So essentially the whole 401k is going to a first time home purchase. Also we live in a state with no state income tax. can you please tell me if I am right to assume that there will be a 10% tax off the top of the 9k and then when we file our 2014 taxes we should add the ~8k 401k as income, putting us at ~70k on our taxes?
March 28, 2014
You are correct to assume the 10% penalty tax applies for a home purchase. As for the rest of your questions, I cannot answer them without knowing more about your situation.

Have you considered a 401(k) loan instead of a distribution?
Clarksville, TN  |  January 29, 2014
we got a 401k distribution in 2012 when my husband was terminated instead of having it rolled over, we received a 1099r in 2013 and reported it. However my electronic tax preparer is asking if we withdrew from a qualifying plan in 2012 and how much. Why are we being asked again on last years taxes and if we didn't get a 1099r again, why would we have to report any distributions again that we already did last year. Thanks
January 29, 2014
I don't know why you are being asked. You can try answering the question and see if it affects your taxes due. Other alternatives are to call/email the support center for the service you are using or consult with a certified tax professional.
Charlie M.
Colorado Springs, CO  |  January 10, 2014
I am thinking about taking an early distribution from a retirement plan set up through my former employer. That employer is located in California and I was told on top of the 10% federal penalty, there is a 2.5% California State penalty. I no longer live there, but now live in Colorado. Would that make me fall under the penalty of Colorado's early retirement distribution penalty, and if so, what is Colorado's penalty?
January 10, 2014
Tax issues tricky are for Bills.com to answer because we never have enough information about readers' circumstances. With taxes, one small fact can make a huge difference in which answer is correct. Consult with a tax preparer who has experience in Colorado state law.
Kc0524 C.
Acworth, GA  |  December 31, 2013
I had to resign from my job due to being a military spouse and change of duty station. I have been looking for employment for about 6 months. My unemployment benefits have run out. Am I able to waive the 10% penalty for withdrawal because of my situation.
January 02, 2014
What you describe does not meet the narrow exceptions the IRS lists for penalty-free withdrawals, unfortunately.
Becky J.
New York, NY  |  September 26, 2013
Trying to help a friend. Due to financial hardship, he fell behind in his child support. He made monthly payments but under the full amount. He ended up owing $15K. Five yrs ago he moved from State X to State Y where his son lives. He then started making payments directly to State Y, but State X started treating him as if he never made payments. Now State X says he owes $60K not $15K. State Y got a QDRO for $60K based on State X's info even though State Y has his payment records. Last week $60K was taken out of his 401K & sent to his son. Prior to this, State X & Y refused to speak to each other to verify the amount. He got the run-around since State X contracts out its child support services with people refusing to speak to him. State X & Y had his old State X address & sent notices there even though he repeatedly said he moved. He made multiple in-person trips trying to solve this huge debacle. The 401K administrator also used the old State X address to notify him when they have his State Y address on file. He never got any notices. Now $60K has been taken from his 401K when he owed $15K. He's now responsible for taxes on $60K. No chance of getting part of the $60K back since the son's mom hates him.

Questions: (1) When the amount taken from the 401K pursuant to the QDRO is WRONG, is there any tax relief? He can't afford the taxes on $60K. (2) Is he liable for the 401K withdrawal penalty or only income taxes on the $60K? (3) ANY ideas or suggestions?
September 27, 2013
Suggest to your friend that he consult with a lawyer in his present state of residence who has experience litigating family law issues. Also suggest he consult with a tax lawyer about any federal or state tax liability he may have.
Suzanne E.
Sheboygan Falls, WI  |  September 19, 2013
My husband is 56 and he is taking early retirement. He wants to cast out part of his 401K but have read this information and still not sure what will be taken out and when. Will the taxes be taken out up front before he gets the money? Also say it's $10,000 what kind of taxes will be taken out and if it is $2,000 the IRS will just add the extra $2,000 to our taxes at the end of the year?
September 19, 2013
The 401(k) distribution forms your spouse will receive from the plan administrator will answer most of your questions.

In the form, your spouse will specify how much in taxes the 401(k) administrator should withhold for taxes, thought there may be a minimum amount that the administrator requires to be withheld. In general, it's better to withhold a bit more than you estimate that you need to so that when you file your 2013 tax returns in 2014 you will see a refund rather than an unwelcome balance due. Any money that is withheld from the withdrawal will be credited to your taxes paid
Darro S.
Mariposa, CA  |  August 14, 2013
I took an early retirement offer and lumped-summed $100k for a mobile home on property that I own and still make payments on. My question is, can I claim the first-time home buyer credit and since I am age 56 and just retired, are there any other credits or one-time deals for people who do this for their primary residence? The federal government already kept $25k for taxes on the $100K.
August 14, 2013
As I write these words in August 2013, I am not aware of any federal first-time home buyer tax credits available to people buying homes in 2013. However, your state or local municipality may have first-time home buyer credits. Check your state, county, and city/town Web sites to learn if any home-buying credits are available.

Talk to a tax preparation specialist to learn if the amount withheld was correct in your circumstances.
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