401(k) accounts are designed to let you save for retirement. In exchange for your agreement to leave the money alone until you reach 59 1/2, the IRS allows you to wait to pay taxes on it until you pull it out. When you withdraw from it before you turn 59 1/2, the IRS doesn't just collect the taxes that you would have had to have paid. It also slaps you with a 10 percent penalty that is taken directly out of the 401(k) account.
Early Withdrawal Withholding
If you pull cash out of your 401(k), the 401(k) plan administrator will usually have to withhold taxes from the check or wire transfer that it sends you. Even if you don't think that you'll have to owe taxes because you usually get a refund, the plan will still withhold the money. For an early withdrawal, the administrator won't just withhold the 10 percent penalty, either. Plans usually pull out 20 percent to give you a head start on the other taxes that you'll owe.
Beyond the Penalty
The 10 percent penalty is just part of what it costs you to take an early withdrawal from your 401(k). Since the money that you put into your plan was tax-free, every penny that you take out is subject to income tax for both the federal government and your state. For example, if you withdraw $5,000 and pay taxes in the 15 percent federal bracket and have 5 percent state tax, you will only get $3,500 after all of them. You'll pay a $500 penalty, $750 in federal income tax and $250 in state income tax. In addition, the money that you pull out won't be working for you and growing for retirement any more.
Not every withdrawal from a 401(k) is subject to a penalty. When you directly roll cash over into another account -- like transferring a 401(k) from a former employer's plan to an individual retirement account -- the transfer can be penalty- and tax-free. You can usually also withdraw penalty-free if you become disabled, use the money to pay for higher education, or have to pay high medical expenses, among other reasons. Withdrawals after you turn 59 1/2 are also penalty free.
Alternatives to Withdrawals
Given that taxes and withholding can take a big bite of your 401(k) withdrawal, you might want to consider alternatives. Some 401(k) plans allow you to borrow up to half of your balance, up to $50,000. You'll have to pay interest on the loan, but you won't have to pay tax on the withdrawal as long as you pay the loan back within a set period -- usually five years. Tapping other funds or even borrowing money might work out to be less expensive. If you have a Roth IRA, you can also withdraw money tax- and penalty-free at any time as long as it's the money you put in instead of the investment growth from the IRA.
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