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MAY 21, 2013

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?

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401k answers
Bill's Answer: Answered by Bills.com Staff

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 Taking money out of a 401(k) account can thus result in a tax obligation of 35% or more of the total amount withdrawn.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

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Comments (29)


Terry H.
April 07, 2013
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
Bills.com
April 11, 2013
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.
Brad P.
Stagecoach, NV  |  February 22, 2013
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
Bills.com
February 25, 2013
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.
Eugene P.
Irvine, CA  |  April 23, 2012
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.
Bills.com
April 24, 2012
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.
Jason C.
Madison Heights, MI  |  April 16, 2012
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???
Bills.com
April 16, 2012
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.
Nathan M.
Brownsville, OR  |  April 05, 2012
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?
Bills.com
April 06, 2012
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.
Gerardo A.
Munroe Falls, OH  |  March 25, 2012
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?
Bills.com
March 25, 2012
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."
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Bills.com
April 01, 2010
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.
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William S.
Hillsboro, OR  |  January 30, 2011
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
Bills.com
January 31, 2011
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.
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HERBERT K.
North Port, FL  |  May 30, 2011
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.
Bills.com
May 31, 2011
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.
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Vance S.
Tupelo, MS  |  July 10, 2011
I don't understand why people keep asking the same question. Are people reading this page before they ask a question.
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Herbert K.
North Port, FL  |  July 10, 2011
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.
Bills.com
July 11, 2011
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."
Anonymous .
April 01, 2010
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.
Bart S.
June 15, 2009
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!
Amy .
June 14, 2009
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
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