If you've lost your job, your 401(k) plan might be very tempting to raid to make ends meet. Before you try to take money out, make sure you're aware of the taxes and penalties that will apply. Because of the taxes and penalties, you usually want to exhaust all of your other options before tapping your 401(k).
Unlike IRAs, which allow you to take distributions at any time, 401(k) plans only permit distributions in certain circumstances. However, these circumstances include if you leave your job, regardless of whether it was your fault or not. As a result, if you are unemployed, you can take money out of your 401(k) plan. If you take a distribution from a traditional 401(k) plan, the whole distribution is taxable income. If you take the distribution from a Roth 401(k) plan, you have to split the distribution between the taxable earnings and tax-free contributions based on the makeup of the account.
If you're under 59 1/2 when you take a distribution from your 401(k) plan, the IRS deems it a non-qualified withdrawal. As a result, you have to pay an additional 10 percent tax penalty on the taxable portion of the withdrawal. For example, if you take a fully taxable distribution from a traditional 401(k) plan, the 10 percent penalty applies to the whole distribution. If you take an $8,000 early distribution from a Roth 401(k) plan and $3,000 is taxable, the penalty only applies to the $3,000 taxable portion.
No Generic Exception
"Unemployment" is not an exception from the 10 percent additional tax, unless it is due to a disability or you are at least 55, so unless you've got a more specific hardship, you will owe both the deferred income taxes and the 10 percent penalty. For example, if you have medical expenses that exceed the threshold percentage of your income or if the IRS levies your 401(k) plan, you can remove those amounts without paying the penalty. However, you'll still owe income taxes.
If you take a 401(k) plan distribution while unemployed, you'll receive a Form 1099-R that documents the distribution for tax purposes. When you file your taxes, you'll have to use Form 1040 and complete Form 5329 to figure your penalty or, if an exception applies, document your exemption. Report the distribution as a pension and annuity distribution.
Mark Kennan is a writer based in the Kansas City area, specializing in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."