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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  • 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

281 Comments

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  • CG
    Dec, 2012
    Chris
    Is it worth the penalty to take money out of my 401(K) to get rid of a 20K credit card debt?
    0 Votes

    • BA
      Dec, 2012
      Bill
      Chris, I don't think there is a one-size-fits-all answer to your question. The interest rate you pay on your credit cards is an important factor, as is the tax bracket you're in, and size of your retirement account. Remember, it is not just the penalty you have to factor in, but the need to include the disbursement as income (as well as the future loss of income that you could gain from holding the money in your retirement account as you originally intended).

      Run the numbers, figuring out the total cost to pay off your credit cards at your anticipated rate of payment and compare it to the costs in taxes and penalties for withdrawing from your 401(k).
      0 Votes

    • MT
      Dec, 2012
      Morcasa
      Can you tell me if there is a website that can help calculate the fed and or state income tax that will apply to this distribution, depending on info using last year returns and state of residence? I am in the same position with deciding whether I want to withdraw to cover a debt. I have heard that if if you move into a new tax bracket, the tax for the increased income is at a higher rate, however the previous income remains taxed at the lower rate. Any guidance or direction is appreciated.
      0 Votes

    • BA
      Dec, 2012
      Bill
      Here is some information I received from our friends at Freedom Tax Relief:

      TurboTax has a free online calculator called "TaxCaster 2012" that is pretty user-friendly. Depending on the type of account the distribution is from, age of the taxpayer, and whether any exception applies, the distribution may be subject to an additional 10% early withdrawal penalty. I am not aware of any similar calculators for states, but some paid tax software programs have estimating features that will do state calculations as well.

      The second part of your question is about progressive income rates. If the distribution moves your taxable income into a higher tax bracket, it will in effect cause some of your total income to be taxed at a higher rate.
      0 Votes

  • AB
    Jul, 2012
    Adrian
    I'm going through a divorce, I'd dont want to displace my children, in order for my wife to financially afford the house I've considered paying down the principal with proceeds from my 401K If I wait for a QDRO, woud this transaction be exempt from the 10% penalty, but still be considered as taxable income? If I choose to waive the QDRO, do I face a 10 or 20% early withdrawal penalty? Thanks for your help
    0 Votes

    • BA
      Jul, 2012
      Bill
      According to the IRS, a Qualified Domestic Relations Order (QDRO) is a judgment or order for a retirement plan to pay child support, alimony or marital property rights to a spouse, former spouse, child or other dependent of a participant. For tax purposes, a spouse or former spouse who receives QDRO benefits from a retirement plan reports the payments received as if he or she were a plan participant. This means your soon-to-be-ex-spouse can roll the distribution into an IRA to avoid any penalty taxes. I am not aware of a tax-free manner for you to pay-off a mortgage for your soon-to-be-ex-spouse's house without you paying a tax penalty. However, after your administrator receives the QDRO order, it may be possible for your ex-spouse to take a distribution tax-free for the purpose you described.

      It is impossible to give you any tax planning advice without knowing more about your situation. If, for example, you are high-income and your spouse is low-income, it may make more sense for her to roll the QDRO into an IRA, and then take distributions as needed.

      Before taking any steps that will impact your finances, be sure to consult with your lawyer to understand the implications of your actions.
      0 Votes

  • AA
    Jul, 2012
    Anoymous
    Hi, I no longer work for my employer and I will not have a full time job for quite some time. I want to pull out the money I have in there to help me out with my current financial situation ($800), what should I do?
    0 Votes

    • BA
      Jul, 2012
      Bill
      You should contact the 401K plan administrator. Remember that you will pay a penalty and have to declare the withdrawal as income on your taxes for 2012 that are due next April.
      0 Votes

  • EM
    Jul, 2012
    Eddie
    Hey, I'm 28, was only in the Army for 3 years, but I put ALL my money in the TSP, now I want it out. Honestly, I had no idea they would keep 20% income tax?? I'm ok with the 10% penalty for early withdrawal, but how can I avoid losing 20% of MY money that I earned while in the service, and who gets that money(where does it go), and why???? I would have been better off just putting it in a savings account, I'm a little upset about losing my EARNED money just because I elected to put it in a safe account that had the ability to accrue me a little interest over the past 3 years. Can I transfer it to an outside account or other 401k type to avoice TSP's 20% tax?? Thank you so much.
    0 Votes

    • BA
      Jul, 2012
      Bill
      A Thrift Savings Plan (TSP) is a retirement savings and investment plan for federal employees. It is, in essence, the same idea as a 401(k). It is not intended as a savings account. It is intended to be a nest egg waiting for you when you retire. To encourage people to leave their TSP accounts untouched until they reach retirement age, the rules require the TSP administrator to collect a stiff penalty if there is an early distribution. TSP savers have the option to roll their TSP account balances into an IRA when leaving government service. However, the rules for taking a distribution from an IRA are equally stiff. See the TSP.gov Taxes on Your Withdrawal Web page to learn more.
      0 Votes

  • BF
    Feb, 2012
    Brittany
    I withdrew on my 401K to do repairs on my home due to flooding and mold. Having the conditions stay without repair would have caused medical issues and further home stability issues if they were to go on unrepaired. Could this be considered hardship or does this not qaulify?
    0 Votes

    • BA
      Feb, 2012
      Bill
      Even a hardship withdrawal is subject to penalties and taxes, unless it meets a narrow set of circumstances. I don't believe that your situation falls into one of the permissible penalty-free categories.
      0 Votes