A 401k is a retirement plan that is created and maintained by your employer. Your contribution is taken out of your paycheck and the your company may offer a special program wherein the company will match your contribution up to a certain percentage of your income. The contributions to a traditional 401k plan are made with pre-tax dollars so you do not have to report those contributions as income.
You are allowed to start taking qualified distributions from your 401k plan when you turn 59½; when your company terminates the plan without creating a replacement; or if you are disabled or leave your job after age 55. If you die, your beneficiary can withdraw money as a qualified distribution. If you withdraw money under any other circumstances, it is considered an early withdrawal.
When you withdraw money from a 401k you must include the money that you have withdrawn as income on your federal tax return. By rule, 20 percent of the distribution must be withheld for estimated tax payments. In addition, you must pay a 10 percent penalty for early withdrawals on top of any taxes you owe.
There are several exceptions that allow you to withdraw money from your 401k before you meet the qualifying conditions. Note that the IRS says qualifying financial hardship must be "immediate and heavy" to necessitate withdrawal from the 401k plan. Exceptions that allow you to withdraw money include large medical expenses; purchasing a home; paying for higher education expenses for yourself, your spouse or your dependents; payments to prevent yourself from being evicted or having your home foreclosed on; funeral expenses or major home-repair costs.
With some 401k plans, you are allowed to take out a loan against the value of your plan. This loan is not taxable as long as the loan is for no more than 50 percent of the value of your 401k plan; is for no more than $50,000; and will be repaid within five years.
The 401k plan is a tax-advantaged plan that was instituted to give an incentive for individuals to save for retirement. The extra penalty for early withdrawals is used to prevent individuals from abusing the tax advantages by not saving the money for retirement.