A 401(k) plan is a tax-advantaged retirement plan set up by an employer for its employees. Employees can contribute a portion of their before-tax wages into the plan; in some cases, employers match some or all of the contribution. There are many reasons you may want to withdraw money from your 401(k). You may need the money for unexpected expenses, want to transfer it to a new employer, or want to take out money in your retirement. Each type of withdrawal has tax consequences and its own administration procedure.
A 401(k) plan allows you to contribute up to a maximum annual amount toward your retirement and get a tax break doing it. It comes directly off your paycheck and into your plan. You receive regular statements showing the balance of your account and the investment activity. The fund grows without tax until you withdraw it. If you withdraw it after you turn 59 1/2 years old, you pay tax on the withdrawal only. If you take it out before then, there is a penalty in most cases.
Withdrawing Money from a 401(k)
Every company with a 401(k) plan has an employee designated as the plan administrator. The administrator coordinates with the investment company that owns the plan and is responsible for setting up new employees on the plan and making any changes. If you want to withdraw money from your 401(k) for any reason, go to the plan administrator and obtain the paperwork that you have to fill out for the withdrawal. The administrator can walk you through the steps required, including choosing which method of payment you prefer and when you would like the withdrawal executed.
Penalties for Early Withdrawal
In general, if you pull funds out of your 401(k) before you turn 59 1/2, not only do you pay tax on the withdrawal, but you also incur a 10-percent penalty from Uncle Sam. There are exceptions to the penalty rule, including using the funds to pay medical expenses over 7.5 percent of your gross income, being required to withdraw due to a divorce settlement, or if you're over 55 and quit your job. Thirty percent of your withdrawal is withheld by your employer and remitted to the IRS for taxes. When you claim the withdrawal as income, you get credit for the amount withheld on your personal tax return.
When you change employers, you have some options as to what to do with the 401(k) balance left with your former employer. You can request a withdrawal of all or part of the balance. If you are younger than 59 1/2, it counts as an early withdrawal with the resulting IRS penalties. You can choose to leave it alone and let it grow: You can't contribute any more to it, but you can leave the plan in place if the balance is over $5,000. The third option is to roll it to a new employer's 401(k) plan or into an individual retirement plan. If you choose the rollover option, the plan administrator of your previous employer initiates the paperwork to make a direct plan-to-plan transfer. In this type of rollover, there are no penalties or tax implications. It's all handled behind the scenes, and the money stays tax-deferred until its eventual withdrawal.
Angie Mohr is a syndicated finance columnist who has been writing professionally since 1987. She is the author of the bestselling "Numbers 101 for Small Business" books and "Piggy Banks to Paychecks: Helping Kids Understand the Value of a Dollar." She is a chartered accountant, certified management accountant and certified public accountant with a Bachelor of Arts in economics from Wilfrid Laurier University.