Your 401(k) plan was intended for retirement savings, but if you come across a financial rough patch, you might be tempted to tap out early. If you do, the distribution has a negative impact on your taxes, especially because you're under 59 1/2 years old. Because of this, the distribution is considered an early withdrawal and the IRS wants a bigger cut of the proceeds.
A withdrawal from your 401(k) plan adds to your taxable income for that year because your contributions weren't counted as taxable income for the year you put the money in. The Internal Revenue Service taxes the distributions at your marginal tax rate, so the more other income you have during the year, the higher the tax rate you'll pay on the 401(k) distributions. Plus, if your 401(k) withdrawal is large enough, it might push you into a higher tax bracket.
Early Withdrawal Penalty
When you're under 59 1/2, the IRS also hits you with a 10 percent early withdrawal penalty on the taxable portion of your distribution. For example, if you have a $3,000 early withdrawal from your 401(k) plan, your taxes show not only ordinary income taxes on the distribution, but also an additional $300 penalty. You can avoid the penalty only if you qualify for an exception.
There are only a few exceptions to getting out of the early withdrawal penalty, and even if one applies, it doesn't get you out of the income taxes. If you suffer a permanent disability, you can take out as much as you want penalty-free. If you get divorced and the court issues a qualified domestic relations order, you're also offer the hook on the penalty for the amount of the order. Finally, if you have medical expenses exceeding 10 percent of your adjusted gross income, you can withdraw the amount of those excess expenses without paying the extra penalty.
Though the net result will still be the same, you might not be in quite as bad of shape come tax time as you might be anticipating. Every withdrawal from a 401(k) plan is subject to a minimum of 20 percent income tax withholding, which, depending on your income tax bracket, may be too little, just right or maybe even not enough. For example, if your 401(k) distribution is your only income for the year and you fall in the 10 percent tax bracket, add in the 10 percent penalty and your total due is 20 percent. But, if you're in a higher tax bracket, you'll have to pay the difference come tax time.
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