Employer-sponsored 401(k) plans often contain a mixture of employer and employee contributions and these accounts grow on a tax-deferred basis. Generally, you have to pay income tax on 401(k) withdrawals and, in some instances, you may also have to pay tax penalties. If your 401(k) plan has a provision for a Roth 401(k) you can potentially avoid both income tax and tax penalties on your withdrawals.
Employer contributions to 401(k) plans are always made with pretax money, and employee contributions generally are pretax as well. You have to pay state and federal income tax on both the original contributions and the account earnings at the time of withdrawal. Withdrawals made after you reach the age of 59 1/2, if you become disabled or if you are the pay-on-death beneficiary on a 401(k) are classified as qualified withdrawals. Most other types of withdrawals are nonqualified and subject to a 10 percent federal tax penalty in addition to regular income tax.
Required Minimum Distributions
Income taxes are a deterrent to making 401(k) withdrawals but you cannot avoid taxes simply by keeping your funds in the account indefinitely. You must begin making withdrawals from your 401(k) during the year in which you turn 70 1/2. Withdrawal requirements are based upon your account balance and projected life expectancy. Failure to take a required minimum distribution results in a tax penalty equal to 50 percent of the amount that you were supposed to withdraw.
Every 401(k) plan must include an option for pretax contributions, but your employer may also include an option for post-tax contributions. After-tax 401(k) provisions are referred to as Roth accounts and work similarly to Roth individual retirement accounts. You do not have to pay income tax or penalties on withdrawals of your own contributions. However, you cannot make a withdrawal while still working unless you experience a financial hardship such as foreclosure or a major medical emergency.
You do not have to pay income tax on withdrawals of your Roth 401(k) earnings as long as you keep the money in the account for at least five years. The five-year rule also applies to Roth IRAs except that for withdrawal purposes, your Roth IRAs are counted as one single account. In contrast, Roth 401(k)s held with different employers are counted separately and each one is subject to the five-year rule. Withdrawals prior to the five-year mark are subject to income tax and a 10 percent penalty although you only pay this on your earnings and not the principal.