Employee-sponsored 401(k) savings accounts allow you to save for retirement while deferring your income tax liability on the funds added to the account through direct contributions, payroll withholding and employer contributions. When funds are withdrawn from the account, you must pay income taxes at your current tax rate on the total withdrawal.
Because payments received from your 401(k) account are considered income and taxed at the federal level, you must also pay state income taxes on the funds. The only exception occurs in states without an income tax. Your 401(k) plan may offer you the opportunity to have taxes automatically withheld from a withdrawal. If you are unsure if your account offers this option, contact the administrator.
If you live in a county or city that levies a local tax on income, your withdrawal from a 401(k) plan is subject to taxation at the local tax rate as well. Many local income tax districts have their taxes collected when you file a state income tax return, so you may not have to file an additional return to pay this tax.
If you do not wait until the age of 59-1/2 to withdraw your 401(k) funds, you may pay a penalty tax in addition to federal, state and local taxes. In most circumstances, an early withdrawal triggers a penalty equal to 10 percent of the withdrawal amount. For example, if you withdraw $10,000, you must pay your taxes and then a $1,000 penalty for using the funds prior to reaching the minimum age.
The IRS allows for hardship exceptions that allow you early access to your 401(k) funds without the 10 percent penalty. If you or a member of your immediate family needs access to medical care, you may withdraw funds without penalty. You also may withdraw money to purchase a principal residence, to save it from foreclosure or to make certain types of repairs to the property. Withdrawals also are allowed for education expenses that belong to you or a member of your immediate family within the next 12 months and can be used to pay for a funeral for you or a member of your immediate family. While you do not have to pay the 10 percent penalty on these withdrawals, it is important to note that you still will owe full income taxes. For the purposes of early 401(k) withdrawals, consider your immediate family to consist of you, your spouse, children, other dependents and your beneficiary.
Ashley Mott has 12 years of small business management experience and a BSBA in accounting from Columbia. She is a full-time government and public safety reporter for Gannett.