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Tax Implications of Early 401(k)

Original post by Tom Gresham of Demand Media

A 401(k) plan allows you to contribute a portion of your paycheck directly into an investment account that your employer sponsors. The plans offer a tax advantage because your contributions to the plan are made before income tax is applied to your income. These plans enable you to save for retirement, deferring taxes until later in life. Because the plans are geared for retirement, however, you risk a tax penalty for withdrawing funds early from the account.

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Penalty Tax for Early Withdrawal

If you remove funds from your 401(k) before the age of 59 1/2, you will be required to pay federal income tax on that money, as you would if you received distributions after that age. However, in addition to the income taxes on the gross income the distribution represents, you typically also will have to pay a 10 percent additional tax, which is called a penalty tax. You will have lost the tax advantages of contributing to the 401(k) in the first place.

Loans

Some 401(k) plans enable participants to use their accounts for loans, often without restrictions on what expenses the money covers. You're essentially borrowing from yourself, and there are no tax penalties. However, you still have to repay the loan, and you have to pay interest on the money you borrowed. According to CNN Money, plans typically limit you to borrowing 50 percent of your vested account. While you are repaying the loan, you might not be allowed to contribute additional funds to your plan.

Late Job Loss and Scheduled Withdrawals

The IRS does not apply the 10 percent penalty tax if you withdraw funds from your 401(k) after you have retired or lost your job if you are 55-years-old or older. According to CNN Money, you can also withdraw funds early without the penalty tax on a scheduled basis. The amount you receive in routine payments would be based on how many years you have until you turn 59 1/2, requiring a minimum of five years. You would still pay federal income taxes on the money.

Miscellaneous

There are a number of miscellaneous withdrawals that often allow 401(k) participants to receive relief from the penalty tax for receiving funds before they turn 59 1/2. The tax break sometimes depends on guidelines in an employer's plan. Hardships, such as a disability, are one reason for withdrawal that does not carry the penalty tax. You could receive a break if the money is necessary for education expenses, critical housing expenses, funeral expenses or medical expenses. The penalty tax does not apply if the IRS levies funds from the plan, if you are distributing the funds to someone else under a domestic relations order or if the distributions are from elective deferral accounts that are qualified reservist distributions, according to the IRS.


                   

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About the Author

Tom Gresham is a freelance writer and public relations specialist who has been writing professionally since 1999. His articles have appeared in the "Washington Post," "Virginia Magazine," "Vermont Magazine," "Adirondack Life" and the "Southern Arts Journal," among other publications. He graduated from the University of Virginia.


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