Losing your job can leave you short on cash. Before you rush to tap your 401(k) plan, make sure you've accounted for the tax consequences of your distributions, as you can end up owing extra in penalties when you take an early distribution. However, in some circumstances, you don't have another choice.
When you take a distribution from a 401(k) after you leave your job, you can withdraw the money, but you're going to have to pay income taxes. The money is taxed as ordinary income, so it's taxed at your marginal tax bracket. For example, if you're in the 25 percent bracket and you take out $5,000, you'd owe $1,250 in income taxes. If your distribution is large, you might find that some of your distribution falls in a higher tax bracket.
In addition to ordinary income taxes, if you're under 59 1/2, you're taking a nonqualified distribution, and nonqualified distributions are subject to an extra 10 percent tax penalty. Exemptions from the penalty are available, but terminating your job, even if its completely beyond your control, isn't one of them. However, you can exempt your distribution from the penalty if you are permanently disabled or if you are over 55 when you leave work.
When you take an early distribution from a 401(k) plan, your tax return gets a little more complex. You'll receive a Form 1099-R from the bank reporting your distribution. On your tax return, you have to include the distribution as a taxable pension distribution and complete Form 5329 to calculate the 10 percent additional tax penalty. Don't forget to include any money withheld from your distribution as tax withholding on your return so you don't pay extra.
Avoiding Taxes with a Rollover
If you're taking an early withdrawal from your 401(k) plan just because you've left your job, but you don't need the money, consider a rollover to another qualified retirement plan, such as an IRA. Rolling the money over allows you to not only postpone the income taxes until you actually take a distribution, but also to avoid the 10 percent additional tax. To complete a rollover, you have to deposit the money within 60 days of taking the withdrawal from the 401(k) plan.
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