The Internal Revenue Service collects income taxes in several ways. For example, you’re obliged to pay the income taxes you owe when you file your annual return unless you ask for an extension. If you’re self-employed, you must make up to four estimated payments every 12 months. And don’t forget that the IRS can garnish your income and seize your assets if you owe back taxes. But tax withholding is perhaps the most ubiquitous method of IRS tax collection.
Pay as You Go
The American tax system is pay-as-you-go, meaning you pay income tax as you receive income throughout the year. If you are an employee, you are familiar with the income tax your employer withholds from your paychecks and bonuses. You also face withholding tax on various other types of income, from gambling winnings to pensions. For example, your 401(k) plan sponsor might have to withhold tax on your distributions unless certain exceptions apply.
The other pay-as-you-go element of the U.S. tax system is estimated tax, used by people who are in business for themselves. With this method, the taxpayer sends a tax payment to the IRS in April, June, September and January based on anticipated income for the upcoming period. Withholding and estimated payments aren’t mutually exclusive. For example, a self-employed person who makes estimated payments on earnings might have tax withheld from taxable 401(k) distributions.
Tax on 401k Distribution
You and your employer can contribute to your 401(k) plan with pre-tax dollars, and taxes on these contributions are deferred until you later withdraw money. 401(k) distributions of untaxed contributions and earnings on these contributions are taxed as ordinary income at the 401(k) tax rate, which is your marginal tax bracket. In addition, you might have to pay a 10 percent early withdrawal penalty if you distribute money before age 59 ½ unless you qualify for a penalty exception.
Some 401(k) plans include Roth accounts containing post-tax dollars that, when distributed, are not included in your current taxable income and are therefore not subject to withholding. However, any distributions (except rollovers) from a Roth 401(k) plan during the first five years of your participation in the plan are subject to taxation and a 10 percent penalty. This rule differs from Roth IRA regulations that subject only earnings, not contributions, to the five-year test.
Withholding on 401(k) Distributions
Several factors influence how much tax, if any, is withheld when you withdraw money from your 401(k). Some 401(k) withdrawal rules include:
Is the withdrawal directly rolled over to an IRA or another qualified employee plan? Direct, trustee-to-trustee rollovers avoid withholding.
Is the withdrawal periodic or a lump sum? Withholding rules differ for the two. In general, a lump-sum withdrawal from your traditional 401(k) requires your plan sponsor to withhold 20 percent of the distribution amount unless it is a direct rollover.
How much of the withdrawn amount stems from pre-tax contributions and earnings? Only pre-tax dollars create a tax obligation that might require withholding when withdrawn.
Does your state assess income tax? Your plan sponsor might withhold 401(k) withdrawal state tax.
Withholding and Rollovers of Lump-Sum Distributions
You don’t incur taxes or penalties if you roll money from your traditional 401(k) to another tax-qualified retirement plan, with the exception of conversions to a Roth account, which are taxable. Your plan sponsor will not withhold money if it executes a direct, trustee-to-trustee rollover to another tax-qualified account without any distributions to the account owner.
Alternatively, under certain circumstances, you might be able to receive a non-recurring lump sum distribution from your 401(k). This is known as an eligible rollover distribution (ERD), and it requires your plan sponsor to withhold 20 percent. You can choose to roll over some or all of the ERD into another qualified retirement account within 60 days. If you miss the 60-day deadline, the rollover will be disallowed and the withdrawal will be treated as a taxable distribution.
An interesting wrinkle regarding an ERD is that you must replenish the withheld amount when you deposit the money into the receiving account or the shortfall will be treated as a taxable distribution. For example, if you request a $10,000 ERD from your 401(k), your plan sponsor will withhold $2,000 – or 20 percent – and you will receive the remaining proceeds, which is $8,000. If you were to simply deposit the $8,000 into your IRA within the 60-day deadline, you would trigger taxes and possibly an early withdrawal penalty on the withheld $2,000. To avoid this fate, you would need to add $2,000 from another source to your ERD proceeds and deposit $10,000 into your IRA.
You cannot roll over non-ERDs. These typically arise from a hardship distribution, a required minimum distribution, one of a series of substantially equal periodic payments, a loan treated as a distribution, corrective distributions of excess contributions, the cost of life insurance coverage for policies owned by the 401(k) or dividends paid on employer securities.
Calculating Tax Withholding
The IRS imposes penalties and interest when you under-withhold your income. To avoid these extra expenses, you can request additional tax be withheld from your sources of income, including 401(k) distributions. For various reasons, you can request the plan sponsor withhold other than the standard 20 percent from a 401(k) distribution. These reasons may include that you are liable for a 10 percent early withdrawal penalty and wish to increase the withholding amount, you are receiving substantially equal periodic payments, which are not subject to the mandatory 20 percent withholding, you are in a high-income bracket and would like extra tax withheld to avoid underpayment, you have under-withheld other income, such as salary or you are self-employed and do not want to account for the distribution when you figure your estimated tax payments.
You use IRS Form W-4P Personal Allowance Worksheet or the IRS Withholding Calculator to instruct your 401(k) trustee how much tax to withhold. You use these tools to specify your appropriate number of personal allowances, which reduce the amount of tax withheld. You can also use Form W-4P to specify that extra tax or no tax be withheld. Notwithstanding Form W-4P, all ERDs are subject to 20 percent withholding.
Using the IRS Withholding Calculator
The IRS Withholding Calculator uses the information you enter to determine the number of personal allowances you should request from your employer or plan sponsor. The information you’ll enter includes your filing status, job status, number of dependents, whether you contributed to a pension or cafeteria plan this year or received taxable fellowship or scholarship money, tax credits you qualify for, whether you’re over age 65 or blind, gross wages, bonuses, year-to-date and last paycheck withholdings, pay frequency, work dates, nonwage income (including 401(k) distributions), income adjustments and deductions.
The calculator responds with your anticipated income tax for the year, the number of allowances to claim and any additional amount to withhold. Transfer the results to Form W-4P and submit the form to your plan sponsor.
Form W-4P has a checkbox you can use to indicate that you do not want any federal income tax withheld from your 401(k) distributions. But note that this does not apply to ERDs, which automatically are withheld at the 20 percent rate. You can use Form W-4P if you want more than 20 percent withheld from an ERD. If you don’t submit the form, the plan sponsor will withhold taxes on periodic distributions as if you file jointly and claim three allowances. If you enter an invalid Social Security number on the form, non-ERDs will be withheld as if you file as a single taxpayer with zero allowances.
Eric Bank is a senior business, finance and real estate writer, freelancing since 2002. He has written thousands of articles about business, finance, insurance, real estate, investing, annuities, taxes, credit repair, accounting and student loans. Eric writes articles, blogs and SEO-friendly website content for dozens of clients worldwide, including get.com, badcredit.org and valuepenguin.com. Eric holds two Master's Degrees -- in Business Administration and in Finance. His website is ericbank.com.