Can Dividends From Investments in a 401(k) Be Withdrawn as Ordinary Income?

One of the main benefits of the 401(k) is that it delays taxes on your investment gains. As long as you keep your dividend payments in your 401(k) account, your income isn't taxed. If you received dividend income in a regular brokerage account, the income would be taxable right away, even if you reinvested your earnings. The 401(k) tax break creates a better after-tax return on your money. In exchange for this tax break, the IRS limits the withdrawal of your dividend income.

The 401(k) is designed to be a retirement plan. When you earn dividend income, you are supposed to keep it in your plan until your retire. If you stop working, you can start making retirement withdrawals when you turn 55. If you keep working, you need to wait until you turn 59 1/2 to make retirement withdrawals. When you take out your dividend income through a retirement withdrawal, the withdrawal will be taxed as ordinary income. The 401(k) only delays taxes on your investment gains; it isn't a tax-free account.

If you want to take out your dividend income before retirement, you need to make an early withdrawal. Before you can make an early withdrawal, you need to check with your employer to see whether you plan permits early withdrawals. Not all plans do. If you are allowed to take out your money early, the entire withdrawal will be taxed as ordinary income. You'll also owe an extra 10 percent early withdrawal penalty on the entire amount. This penalty makes it very costly to take out your dividend income before retirement.

There is one other way to take your dividend income out of your 401(k). Some plans let you take loans out of your account balance. If your plan allows loans, you can borrow half of your account balance up to a maximum of $50,000. While you won't owe income tax on your loan, you'll need to pay it back with interest into your 401(k). If you don't, it'll count as an early withdrawal and will get charged taxes plus the 10 percent penalty.