If you take a withdrawal from your 401(k) plan, you're going to have to pay taxes. Uncle Sam gave you a tax break when you put the money in, but he's going to get his share when you take it out. In addition, you might have to pay extra taxes if you can't take a qualified distribution. Knowing the 401(k) distribution rules can help you decide if tapping your nest egg is really your brightest idea.
Taxation of 401(k) Distributions
Almost every distribution you take from your 401(k) plan will be taxed. When you defer money into the plan, you don't include that in your taxable income. When that money grows in the account, you still don't pay taxes. There's no way the Internal Revenue Service is going to let you get away with never paying taxes on the income. The only way a portion of the distribution would be nontaxable is if you put in after-tax money to the 401(k) plan, which most plans don't permit.
If you're not at least 59 1/2 years old, the IRS is going to reach a little deeper in your pocket come tax time. A nonqualified distribution from a 401(k) plan is any distribution you take before reaching the magic age of 59 1/2 (didn't know that birthday was worth celebrating, did you?). Unless you qualify for a specific exception, the IRS tacks on an extra 10 percent penalty. For example, if you're 30 and decide you want to go on a fancy, $10,000 vacation funded by a distribution from your 401(k) plan, you've pay an extra $1,000 on top of ordinary income taxes.
You might be able to weasel your way out of the penalties, but not the income taxes, if you qualify for an exception. The stingy IRS doesn't just hand these out willy nilly and a simple hardship distribution does cut it. Examples of exceptions include if you suffer a permanent disability, if you separate from service after turning 55 or if you have medical expenses exceeding 7.5 percent of your adjust gross income. You also avoid the penalty if the IRS levies your 401(k) plan for taxes you owe. In short, it's unlikely you'll qualify when you're in your 20s and 30s.
Roth 401(k) Alternative
If your company offers it, consider a Roth 401(k) plan if you think you'll be paying a higher tax rate when you take distributions than when you make the contributions. With a Roth 401(k), you can't exclude the contributions from your income, but your qualified distributions do come out tax-free, including all the earnings on the money in the account. However, you can't take qualified distributions until you've had the account open for five years and you're either 59 1/2 or permanently disabled.
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