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401(k) Early Distribution Tax Penalty

401(k) Early Distribution Tax Penalty
Daniel Cohen
Jan 2, 2008
Key Takeaways:
  • 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.
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?

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.