Information on Tax Obligation Due to 401K Withdrawal

If I withdraw from my 401K to buy a house, am I still liable for the penalty?

Bill, I have a question for you. I bought a condominium a year and a half ago. I took the down-payment from my pension plan from work . At that time I was told that I could take that money without any penalty if it was to buy my first home (as it really was), then now the IRS sent me a note that I have to pay taxes for that money. I'm doing it through a payment plan. Some people had told me that it is a mistake because I don't owe money to the IRS for taking that money for that purpose and other people have told me yes. I'm very confused about that. Can you clarify this for me, please?

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Bill's Answer
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The taxes you are required to pay on this withdrawal depends on the type of retirement plan your company has established. Most companies now offer 401(k) retirement savings accounts for their employees, though some companies still use private retirement plans or fixed-benefit pension plans. From the description in your question, I believe that the account to which you refer is a 401(k) plan.

Money deposited into a 401(k) is paid into the account on a pre-tax basis. Your employer takes money from your pre-tax earnings and deposits the money into the 401(k) account on your behalf, along with any contribution made by your employer. Therefore, you have not paid income taxes on the money in your 401(k) account. Because of this, if you decide to withdraw any money from your 401(k) account, you are required to pay taxes on the money at your current, regular income tax rate. For this reason, 401(k) accounts are referred to as “tax deferred” savings accounts.

To learn more about 401(k) plans, I encourage you to read the IRS document Topic 424 - 401(k) Plans.

Distributions

Generally speaking, if an account holder wishes to make an early withdrawal from his 401(k) account, he will be charged a 10% penalty tax in addition to the regular income taxes he will be required to pay on the money. Taking money out of a 401(k) account can thus result in a tax obligation of 35% or more of the total amount withdrawn. For example, if you withdrew $10,000 from your 401(k), you could be charged $3,500 or more in taxes and penalties. The penalties Congress wrote into the 401(k) law are designed to discourage Americans from making premature withdrawals from their 401(k) accounts. 401(k)s are designed to help workers save for retirement and not as a means of saving for other purposes.

You will almost always be required to pay some income taxes on any withdrawal from your 401(k) account, regardless of the reason for the withdrawal. These taxes are due because you have not yet paid taxes on the money deposited in your 401(k) account. While you generally cannot avoid regular income taxes on the 401(k) withdrawal, you can, under certain circumstances, be excused from 10% additional tax penalty charged on most early withdrawals.

To read more about the rules regarding early withdrawals from tax-deferred retirement accounts, read the IRS document 401(k) Resource Guide - Plan Participants - 401(k) Plan Overview and 401(k) Resource Guide - Plan Participants - General Distribution Rules.

Your Next Steps

I think that the best thing you can do in this situation is to consult with a qualified tax attorney or certified public accountant. A professional tax advisor should be able to tell you what taxes you are required to pay, from what taxes you may be exempt, and how to assert any exemptions that you may have. You may also want to contact the IRS directly to discuss your situation and ask what taxes are legitimately owed. Also review the IRS’s 401(k) Resource Guide.

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

Best,

Bill

Bills.com

29 Comments

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  • 35x35
    Apr, 2013
    Terry
    Can you give me a simple explanation to the hardship rule? I'd just like to know if I can make withdrawls from my 401K if I'm fired from my job. Let's assume I've exhausted other avenues of relief such as savings, temporary loans and credit card cash advances. Thanks
    0 Votes

    • 35x35
      Apr, 2013
      Bill
      The problem with simplifying IRS rules is doing so removes any nuances and exceptions. As we all know, tax laws are technical, and any simplification may mislead an honest person and lead them astray. Take the time to understand the rules the IRS shares in the document "401(k) Resource Guide - Plan Participants - General Distribution Rules," a link to which we share in the original article above.
      0 Votes

  • 35x35
    Feb, 2013
    Brad
    Hello I'm 50 years old and have been working for a company for 15 yrs. I have a 401k that my employer is matching up to 6%.I currently have $300.000+ in my account. I'm looking at borrowing 30k to clear up my outstanding credit card debts. I’m told that the interest would be 4.2% which is a lot less than the 14 to 18 % that the cards are currently charging me. Is this a good idea. Also if I were to no longer work for the company in a year or so what would my penalties be. Could I pay the remaining balance off using money in my 401k and of course paying penalties and taxes. Just would like to know if the worst case (losing my job) and paying off the loan early would be better than having the high interest rates of the credit cards. I’m currently having trouble meeting my bills and other financial obligations each month .Needing away to lower my pay outs. Thanks you for any advise
    0 Votes

    • 35x35
      Feb, 2013
      Bill
      Brad, check with your 401k plan administrator and find out the size of the repayment you would have to make on a 401k loan. Compare that payment to the size of the monthly credit card payments you currently make, to see which is better for your monthly cash flow. Because you state that you're having trouble making ends meet, it may not be a good decision to pay off the high-interest debt, even if it would save you money over the long haul, if it creates more stress month-to-month

      If you leave your job, you either have a short time to repay the loan in full (I believe 3 months, but check with the plan administrator) or the unpaid portion counts as a withdrawal and is subject to both taxes and the 10% early-withdrawal penalty. Whether paying the taxes and penalties is better than paying the interest on the cards depends on different factors, including the total income you would show in any year in which the withdrawal counted as income.
      0 Votes

  • 35x35
    Apr, 2012
    Eugene
    Hello, Please help me to understand my situation with early 401K withdrawal. I switched jobs in August of 2011 and we were planing to by a house so I made an early withdrawal from my 401 at 100%. We did not buy the house unfortunately. Let's say I had a total of $10,000 and only received $7,500 in cash due to tax paid for federal and state taxes. Now, when I prepared my taxes for 2011 I receive a form to add to my gross income $10,000. Does it mean that I'm getting double taxed on my withdrawal? Please help.
    0 Votes

    • 35x35
      Apr, 2012
      Bill
      You are not being double-taxed. Just make sure to report the amount that was withheld. If you are confused, you should speak with a certified tax preparer to assist you. The last thing that you want to do is to make an error that will come back to bite you with additional penalties and interest.
      0 Votes

  • 35x35
    Apr, 2012
    Jason
    I took a distribution when I left my last job. I paid 20% on that money. I knew I would pay another 10% at tax time. However, on top of that I'm also being taxed as income? so essentially, I'm paying 50%???? If i had $20K, and withdrew it, I should end up with $14K, correct? Instead, I'm paying taxes on that $14K, which will put me down to around $11K... Is this wrong???
    0 Votes

    • 35x35
      Apr, 2012
      Bill
      You should add the amount you paid in taxes on the distribution in the "Other Taxes" section of your 1040. I believe it's line 58, if memory serves. You may also need to file a Form 5329.
      0 Votes

  • 35x35
    Apr, 2012
    Nathan
    I was fired form my job and had a 401k that my employer contributed to. After my release they took a large sum out only leaving about $4000 in the account. I transfered it to a IRA, but I am wondering what could I be looking at if I withdrew the money. I am 26 and am still unemployed and on unemployment. Unfortunately I need a car and need some money to buy a car, since I gave my car back to the bank because I couldn't afford the payment. How much would I possibly get back?
    0 Votes

    • 35x35
      Apr, 2012
      Bill
      See the "Distributions" section in the original answer above for a general answer to your question. Exactly how much you will pay in taxes depends on your tax rate. You mentioned you are age 26. There is no exception from the penalty taxes you will pay if you use a distribution to purchase a vehicle if a person is less than age 59½.

      Follow the links to the IRS documents above to learn more about 401(k) accounts and taking distributions from 401(k)s.
      0 Votes

  • 35x35
    Mar, 2012
    Gerardo
    the company i work for has a 401k plan, i asked to pull out half of my 401k monies. i knew that i would be taxed, and the money i received was taxed. my question is do i still have to pay more taxes (possibly 10%) or claim it as income?
    0 Votes

    • 35x35
      Mar, 2012
      Bill
      I cannot comment on a reader's detailed tax return without knowing everything going into a his or her 1040 and his or her age. Therefore, the answer to your first question is, "I don't know." The answer to your second question is, "Yes, a distribution from a 401(k) or IRA is taxable income."
      0 Votes

  • 35x35
    Apr, 2010
    Bill
    There seems to be some misunderstanding about how 401(k)s function among readers of my answer above. Contributions to a 401(k) account are pre-tax. Receiving a distribution after age 59½ comes without the 10% penalty tax. Any tax you pay on a 401(k) distribution after age 59½ is not a penalty -- it is a tax at your usual tax rate. In other words, a 401(k) is a tax-deferral plan. It assumes that when you earn your income you are in a higher tax bracket than when you take the distribution. If your employer offers a 401(k) -- participate in it! It is a great deal even if your employer does not provide any matching funds.
    1 Votes

    • 35x35
      Jan, 2011
      William
      My wife quit her job and started a new career. We used a 401k loan for around 3000 when we bought our house. Also she closed out her 401k when she quit her last job. What % are we going to be screw on for her closing out and what % for defaulting on the 401k loan? Thanks
      0 Votes

    • 35x35
      Jan, 2011
      Bill
      When a 401(k) loan is not paid back as agreed, then the amount of money that remains unpaid will be viewed as a disbursement. Both disbursements, the loan not paid back and the account that was closed, will be subject to a 10% penalty for early withdrawal, if it applies, plus you will have to declare the amount disbursed as income and pay income taxes on it. How much taxes you will pay will depend on your tax bracket.
      0 Votes

    • 35x35
      May, 2011
      HERBERT
      Now I am confused. I am told that after 59 1/2 you may draw out your 401 without penalty but must add this to your current yearly income and you are taxed on this amount. Then I read that you are taxed at 20% of your 401. This seems unfair, as that is a higher rate then my current income bracket.
      0 Votes

    • 35x35
      May, 2011
      Bill
      You are taxed according to your current income bracket. If your 401(k) plan's rules require a 20% withholding, you will get a refund when your taxes are due, if you have overpaid.
      0 Votes

    • 35x35
      Jul, 2011
      Vance
      I don't understand why people keep asking the same question. Are people reading this page before they ask a question.
      0 Votes

    • 35x35
      Jul, 2011
      Herbert
      I read all the comments, that is where the confusion came in. When I questioned the company that holds my 401 account I was told that because on my age the 10% penalty would not apply, this I understood. But then they went on to tell me that I would be taxed at 20%, they did not mention that this would be figured in at the end of the year on my income and taxes. They flatly stated I would be taxed at a 20% rate.
      0 Votes

    • 35x35
      Jul, 2011
      Bill
      The company was not clear in what it said, which understandably caused your confusion. A company that handles 401(k) accounts should speak precisely when it comes to account holders' tax obligations for money taken from the account.

      The company should have said, "The required withholding on your disbursement is 20%. If you are taxed at a lower rate, you will get a refund when your tax return is processed."
      0 Votes

  • 35x35
    Apr, 2010
    Anonymous
    It's best not to touch it but... Well, for some people the penalty isn't too bad consider the company match. You aren't really losing money they gain 15% even with penalties, if the company matches all you put into the account. In response to John - If you only put your money into an account just so you can withdraw it without penalty you are really losing company match money.
    0 Votes

  • 35x35
    Jun, 2009
    Bart
    Yeah, you should call or contact your plan administrator. You own the 401k, so you can do whatever you want. You'll owe a hefty tax bill though, so be sure to save funds for tax day!
    0 Votes

  • 35x35
    Jun, 2009
    Amy
    Hello, can a person close out there 401k plan for any reason? Meaning if i can't do a hardship withdrawel can i just close it out and get the money after penalty an tax. I am stuck for money an in my 20's. I have enough years to make the money up again. i have $22,000 in 401k Thank You
    0 Votes

  • 35x35
    Mar, 2009
    Bill
    If you withdraw before you turn 59 & 1/2 years old, you will lose 10% right away. You would then receive a form 1099 for the $16000, which you would have to add on to your tax returns, and pay the taxes as per your tax bracket.
    0 Votes

  • 35x35
    Mar, 2009
    Dan
    If I close out my 401K, which only has 16,000 dollars left in it, how much do I lose right away and how much would I have pay in tax at the end of the year?
    11 Votes

  • 35x35
    Feb, 2009
    Bill
    John, that tax penalty is not really a penalty in this case it is just a deferral of taxes. If you just put money into a bank account, it is after tax income so you are already penalized. If you company matches a 401-K is frequently your best investment (tax free contribution and matched!)
    0 Votes

  • 35x35
    Feb, 2009
    john
    i reccommend anyone thinking of doing a 401k is not to do it! why, if you can make sure you put a % into a bank account you will be better of, then you won't have to pay 25%-35% tax when you withdraw it.
    1 Votes

    • 35x35
      Sep, 2011
      fred
      I agree!! really think about it, Don't just do it, its not your money when you need it. Had to leave job just to get the money. Worked out fine with taxes since we get a refund every year and the taxes and the penalty just canceled the refund.
      0 Votes

    • 35x35
      Nov, 2011
      You are only paying the tax upon withdrawal because you didn't pay tax on it when your employer put the money in your 401k. You pay your current bracket rate when you take it out. If you are 59-1/2 or older you don't pay the 10% penalty.
      0 Votes