Making 401k Withdrawals
Pension plans such as 401k and IRA plans were introduced in order to encourage families to save towards their retirement. So, it is no surprise that the government discourages people from withdrawing money from their 401k funds for anything other than to help fund their retirement.
If you are considering making a withdrawal from your 401k plan, bear in mind that there may be tax liabilities as well as a 10 per cent penalty on certain early withdrawals or distributions.
Our guide looks at the factors you should consider if making a 401k withdrawal.
If you’re thinking about 401k withdrawals
You should consider a 401k withdrawal very carefully. This is because:
- You will be sacrificing the benefit of an earlier 401k plan contribution
- You will be giving up excellent tax benefits (your contribution is tax deductible and the growth of your account is tax deferred)
- You may have to pay tax or a 10 per cent penalty
- You will lose all the potential future investment growth of the money you withdraw
- Due to the annual contribution limits you can’t make up for a previous withdrawal at a later date
401K Withdrawal Rules
With a few unusual exceptions, all 401K withdrawals are taxable as ordinary income. And, you will also have to pay an additional 10 per cent early distribution penalty tax if you have not reached at least age 59 ½ when you take your distribution.
However, exceptions to this penalty include:
- You become disabled
- You die and the account is paid to your beneficiary
- You make an allowable medical expense deduction
- You terminate your employment and you are over the age of 55
You should remember that while all the above exceptions apply to the 10 per cent penalty tax, withdrawals are still subject to taxes such as federal income tax withholding. And, you may even have to make estimated tax payments to avoid withholding penalties.
Withdrawing funds from your retirement fund is a big decision and so you should only do it as a last resort having consulted with your tax advisor or financial consultant.
If I make a large 401k withdrawal, do I pay tax at my current bracket?
Carolyn – Not necessarily. Remember that large withdrawals may put you into a more expensive tax bracket, and that a mandatory 20% tax withholding is taken out up-front so the cash you wind-up with will be less than the original withdrawal amount.