Information on Tax Obligation Due to 401K Withdrawal

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READER QUESTION

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

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Bills.com Resident Expert
Dec 12, 2011
BILL'S ANSWER

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; basically, 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 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 th IRS document Topic 424 - 401(k) Plans.

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 Taking money out of a 401(k) account can thus result in a tax obligation of 35% or more of the total amount withdrawn; for example, if you withdrew $10,000 from your 401(k), you could be charged $3,500 or more in taxes and penalties.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 promulgated by the IRS are designed to discourage Americans from making premature withdrawals from their 401(k) accounts, since 401(k)s are designed to help workers save for retirement, not as a means of saving for other purposes.

You will almost always be required to pay your 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 my knowledge, using the money withdrawn from a 401(k) to purchase a home does not excuse one from the 10% penalty tax; such an exemption does exist for IRA accounts, but I do not believe that the same rule applies to 401(k) accounts. Therefore, you may be required to pay the taxes the IRS has claimed that you owe, unless your retirement account is not a 401(k), in which case different rules may apply.

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.

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

Comments (17)


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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
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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.
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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.
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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."
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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.
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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!
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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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Bills.com
March 09, 2009
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.
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Dan W.
March 07, 2009
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?
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Bills.com
February 27, 2009
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!)
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John .
February 26, 2009
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.
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Fred S.
B/o Barrington, NJ  |  September 07, 2011
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.
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November 26, 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.
Thanks for your feedback!

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