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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?

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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Updated: Sep 23, 2014

401k answers
Highlights

  • Congress permits two types of hardship distributions.
  • File a Form 5329 to report the tax on early distributions.
  • Your plan administrator will send you a Form 1099-R.

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.

I hope this information helps you Find. Learn & Save.

Best,

Bill

Bills.com

307 Comments

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  • JS
    May, 2014
    John
    I have $150,000 annuity. What would the tax penalty rate be if I withdraw it at age 55? This is also my retirement date. Or would this fall under the exception?
    0 Votes

    • BA
      May, 2014
      Bill
      The best source of an answer to a question like yours is to consult with a CPA or qualified tax specialist. The costs in taxes and penalties if you get a wrong answer make it clear to me that professional counsel on this is required.
      0 Votes

  • BK
    Apr, 2014
    Beth
    We are totally confused on what to do and are trying to find some answers. My husband is over 60 and has 120K in his pre-tax retirement account. In Jan 2014 he attempted suicide and has lost his job since then. We cannot make it on my income unless we are able to pull some of his retirement to pay off all the medical, credit cards and vehicles. We need about 20K to do that. I have been told too many different things about the % of the penalty. We would roll the rest over into a 401k account and pull monthly checks from the balance. What I need to know is how much to pull over the 20K to pay the federal taxes and how much to pull over that to pay the state taxes at the end of the year. Due to the fact that he normally makes 45K a year we are not going to be in a higher tax bracket (I hope). This is our only hope to stay afloat and everyone that I talk to wants to charge us to even talk to us and give us advice. We also need to pull enough to buy medical insurance since he had us both on his plan through his employer and to add us to my employer plan it is over 700 a month and we certainly can't afford that. If I don't figure something out I am afraid I am going to come home and find that I can't save him from a second suicide attempt. I would be forever grateful if you could point us in the right direction or give us some advice. Thank you!
    0 Votes

    • BA
      Apr, 2014
      Bill
      There is no quick, one-size-fits-all answer to tax questions like yours. Someone answering your question accurately needs to know your income, the number of dependents, if you take the standard deduction or itemize, any 1099s you receive, if you file jointly or separately, and other relevant facts about your financial situation. Asking the right questions, compiling the information, and answering tax questions takes time.

      For no-cost tax advice, contact the IRS Volunteer Income Tax Assistance (VITA) or the Tax Counseling for the Elderly (TCE) program if you cannot afford to hire a tax professional to review your situation.
      0 Votes

  • SH
    Apr, 2014
    Sam
    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
    0 Votes

    • BA
      Apr, 2014
      Bill
      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.
      0 Votes

  • RP
    Mar, 2014
    Rob
    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.
    1 Votes

    • BA
      Mar, 2014
      Bill
      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.
      0 Votes

  • JD
    Mar, 2014
    JP
    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!
    0 Votes

    • BA
      Mar, 2014
      Bill
      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.
      0 Votes

    • JD
      Mar, 2014
      JP
      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?
      0 Votes

    • BA
      Mar, 2014
      Bill
      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.
      0 Votes