Can Dividends From Investments in a 401(k) Be Withdrawn as Ordinary Income?

A 401k account usually contains shares in mutual funds and stocks, some of which may pay dividends. The plan custodian receives the dividends and the proceeds are either reinvested in other securities or held in a cash account within your 401k plan. You usually have to pay income tax rather than capital gains tax when you withdraw dividends and other money from a pension plan. However, 401k dividend proceeds are not easily accessible and if you withdraw the money, you may have to pay a penalty fee in addition to ordinary income tax.

Taxes that you pay on withdrawals of dividends and other funds from a 401k plan are limited to state and federal income tax, as long as you make a qualified withdrawal. Any withdrawals that you make after reaching the age of 59 1/2 are classified as qualified withdrawals. You can also make a qualified withdrawal if you become disabled, or if you make withdrawals as the beneficiary of a 401k plan. When you reach the age of 55, you can make a qualified withdrawal if you are no longer employed. Other types of qualified withdrawals include withdrawals made to cover some medical costs or to satisfy court orders.

When you withdraw money from a Roth 401k, you pay income taxes on your dividends and other earnings but you pay no taxes on withdrawals of principal. This is because you deposit money into the account on an after-tax basis. However, you can also avoid paying income tax on your dividends and earnings if you keep your Roth 401k open for five years or more and do not access funds until you are 59 1/2 or older.

If you make a non-qualified withdrawal of dividend money or other funds from a traditional 401k or a Roth 401k then you have to pay federal and possibly state income tax, as well as a 10 percent tax penalty. On the Roth, neither the tax nor the penalty apply to the withdrawal of principal. With a traditional 401k, you must start withdrawing money in the year you reach the age of 70 1/2. Your required minimum distributions are based upon your life expectancy. If you do not withdraw the necessary funds, then you incur a 50 percent penalty tax on the amount you should have withdrawn.

Many employers do not allow you to make withdrawals from your 401k until you have retired, because the Internal Revenue Service allows but does not compel employers to give employees access to in-service withdrawals. With an in-service withdrawal you can access your dividends and earnings as well as contributions that you made to the account. However, you can only make such a withdrawal if you have reached the age of 59 1/2, or if you experience a financial hardship such as the threat of foreclosure. In-service withdrawals are subject to the same taxes and penalties as other 401k withdrawals.