Emptying a 401k

There are income tax consequences and possible penalties when you empty a 401k.

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There are smart ways to empty your 401k plan from work and there are not-so-smart ways. Your options depend on your age, employment status with the sponsoring company, whether you are taking out cash or rolling the balance over to another retirement plan and your overall personal financial situation. There are tax consequences to emptying a 401k plan, so be conscious of your income tax rates, both now and your expected income tax bracket in retirement.

Step 1

Inspect your plan documents. Your 401k plan sponsor defines many of the rules that govern your 401k plan. For example, not every plan sponsor allows in-service withdrawals. If you are still employed with the company, you may not be allowed to empty your 401k in the first place. Also, some plans permit hardship distributions, while others don't or have more restrictive criteria on what it takes to qualify. Electing a hardship distribution may help you avoid penalties for early withdrawals, though income taxes will still apply.

Step 2

Calculate the tax consequences. Your balance within the 401k plan grows tax-deferred until April 1 of the year after the year in which you turn age 70 1/2, at which time the IRS requires you to take out required minimum distributions and pay taxes on them. But when you take money out of a 401k, you must pay income tax on the entire distribution in the year in which you took the money out. You may also have state income tax ramifications from the withdrawal.

Step 3

Subtract 20 percent from your withdrawal. This is the percentage your plan sponsor is required to withhold from an early distribution, and forward to the IRS to cover income taxes on the withdrawal. You must pay any additional income tax beyond that amount. However, the IRS will refund any overpayment when you file your individual income tax return if the 20 percent withholding results in you paying more than your tax liability for the year.

Step 4

Calculate penalties. If you are under age 55, or if you still work for the 401k plan sponsor and you are under age 59 1/2, the IRS will assess a 10 percent excise tax penalty on the entire amount you withdraw. This penalty also includes 10 percent of the amount the plan sponsor withholds to pay income taxes.

Step 5

File your taxes. The 401k sponsor will send you a Form 1099-DIV, detailing your distribution and the taxes you already paid. You must claim the distribution on your individual income tax return for that year. However, you will get credit for the 20 percent of your distribution the plan sponsor paid on your behalf.