If you take early withdrawals from your 401(k), you’re likely aware you must pay taxes and penalties at the federal level. Most states don’t impose an early withdrawal penalty, but that’s not the case in California. If you’re a California resident, expect your state to exact its own taxes and penalties.
Federal Taxes and Penalties
If you’re under the age of 59 1/2, you are subject to federal taxes and penalties on 401(k) withdrawals. The IRS hits you with a 10 percent early distribution tax, although certain exceptions apply. These exceptions include:
- Total and permanent disability
- Funds distributed to a former spouse under a Qualified Domestic Relations Order Tax levy by the IRS
- Unreimbursed medical expenses that exceed 10 percent of your annual adjusted gross income
If you are “separated from service” from your employer – an IRS euphemism for if you are fired, laid off or quit – you are not subject to the 10 percent penalty if you reach age 55 by the time the separation occurs.
No matter when you take distributions, money taken out of a 401(k) is subject to tax at your income tax bracket level. Funds placed in a 401(k) during your working life come out of your paycheck pretax, and you don’t pay taxes on the amount or any interest, dividends and capital gains they accrue until withdrawal. After you start taking distributions, the amount is taxed as ordinary income. Most people find themselves in a lower tax bracket after retirement, so the tax bite is less severe than it would have been during the time you were receiving a paycheck.
California Taxes and Penalties
When you take early distributions from your 401(k), expect to pay an additional 2.5 percent in California tax. That means you pay a total of 12.5 percent in extra tax for early withdrawals.
When you reach age 59 1/2 and remain in California, you are required to pay state income tax on retirement savings. California taxes all retirement savings with the exception of Social Security and railroad retirement benefits. For 2017, the maximum California tax rate for individuals is 12.3 percent, which is among the highest in the nation. However, that rate is only for the top earners, so it is possible your tax bite would be considerably lower.
California uses your federal income tax return as the basis for determining the amount of state tax you owe for early and regular 401(k) withdrawals.
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If you qualify for any of the exceptions permitted by the IRS for early withdrawal, California honors those and does not impose the additional 2.5 percent tax. However, if the amount you withdraw from your 401(k) exceeds the amounts of the exception, California taxes the difference. For example, say you withdraw $15,000 to pay for unreimbursed medical expenses, but those expenses only total $13,000. California charges the 2.5 percent tax on the $2,000 difference.
Form FTB 3805P
Whether you must pay the early withdrawal penalty or are claiming an exception, fill out Form FTB 3805P and include it with your California income tax return. Enter your distribution amount on Line 1. If any exception applies, place it on Line 2 along with the corresponding exception code. The codes are listed in the instructions for Form FTB 3805P.