When you retire or face financial hardship, withdrawing from your employer-sponsored 401(k) can help fund your day-to-day expenses. The Internal Revenue Service requires you to include distributions from a 401(k) in your adjusted gross income (AGI) on your tax return, which can affect your eligibility for several income tax credits. Whether you will still qualify for the Earned Income Tax Credit depends on several contributing factors.
The EITC is a tax credit designed to help low-to-moderate income working families keep more of their paycheck. The intentions of the credit are to offset Social Security and Medicare tax and to lower your tax liability to the IRS. If the amount you receive as a credit exceeds the amount you owe the IRS, you will receive a refund for the excess amount. To qualify for the EITC, you must have earned income below a certain threshold, which depends on your filing status and number of dependents.
In most cases, contributions to a 401(k) plan are tax deferred, which means you will not owe tax on the money until you receive distributions. Typically, you cannot take distributions until you are 59 1/2 years old, become disabled or sustain a financial hardship. If you receive income from a 401(k) without meeting these requirements, you will generally have to pay a 10 percent early withdraw penalty in addition to the deferred income taxes.
EITC and 401(k) Income
When determining whether you qualify for the EITC, you must consider your AGI, which includes all earned and unearned income. Although the IRS does not use your 401(k) income when determining the amount of your EITC, the income is used when determining your eligibility. For example, if you are married filing jointly with two children, earn $45,000 in income and receive a $5,000 distribution from your 401(k), your total AGI is $50,000. Because your AGI is more than the $47,162 threshold as of 2013, you do not qualify for the EITC. Without the 401(k) income, you would have qualified for the credit. If you have $30,000 of earned income and $5,000 in 401(k) income, your AGI is $35,000 and you will qualify. The IRS would determine the amount of your EITC based off the $30,000 in earned income -- not including the $5,000 from your 401(k).
If you still qualify for the EITC, the credit can help offset any deferred taxes and penalties you owe for the distributions of your 401(k). The IRS requires financial institutions to withhold federal income tax and the 10 percent penalty on early withdrawals unless you specify with the institution. If you opt not to have taxes withheld from your distributions, the IRS might require you to make estimated tax payments if you expect to owe more than $1,000 in taxes. For more information, refer to IRS Publication 505.
Angela M. Wheeland specializes in topics related to taxation, technology, gaming and criminal law. She has contributed to several websites and serves as the lead content editor for a construction-related website. Wheeland holds an Associate of Arts in accounting and criminal justice. She has owned and operated her own income tax-preparation business since 2006.