Tapping into your 401(k) retirement account isn't a good idea in your 20s or 30s, but sometimes you don't have another choice. If you are taking an early withdrawal, knowing how much will be withheld for federal income taxes helps you budget how much you need to take out to pay your expenses – and how much you might still owe when you file your return.
Minimum 20 Percent Withholding
The Internal Revenue Service mandates that your financial institution withhold a minimum of 20 percent of each 401(k) plan distribution for potential income taxes due when you file your taxes. This rule applies no matter how much other income you have or what you're planning to use the money for. For example, say you are laid off on Jan. 1, have no income all year and live off savings until December, when you withdraw $10,000 from your 401(k). Even though you're not going to owe 20 percent in taxes and penalties, you still have 20 percent withheld.
Additional Taxes Due
Just because you have 20 percent withheld from your 401(k) distribution doesn't mean you won't owe extra when you file your return. If you don't have enough money withheld from your distribution to cover taxes and don't qualify for an exemption from the automatic 10 percent early withdrawal penalty, you will have to pay up when you file your tax return. Exceptions include medical expenses that exceed 7.5 percent of your adjusted gross income (for 2018), suffering a permanent disability, taking a distribution as a result of a qualified domestic relations order or leaving your job after turning 55 years old. Of course, if 20 percent is too much to withdraw based on your annual income, you'll get a tax refund of the excess amount.
Optional Higher Withholding
The 20 percent withholding is just a minimum requirement and, if necessary, you can alter it so your withholding percentage is higher. For example, say you expect to fall in the 22 percent tax bracket and know you'll owe the 10 percent penalty on your withdrawal. You can elect to have 32 percent withheld from your 401(k) withdrawal so you won't owe extra when you file your return.
Rollover to Another Retirement Plan
If you're withdrawing money from your 401(k) with the intent to move it to another qualified retirement plan, such as a 401(k) at a new job or a traditional individual retirement account, a transfer, sometimes called a direct rollover, may be your best option. With a transfer, the financial institution holding your 401(k) funds pays the money straight into your new retirement account, cutting out the middleman and the income tax withholding. And you don't need to worry about missing the deadline for completing the rollover.
Based in the Kansas City area, Mike specializes in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."