When you leave a job you usually have the option of leaving your 401(k) money with your existing administrator or moving it into a new qualified plan, such as the 401(k) at your new employer or an individual retirement account. If you take possession of the money in your 401(k), you risk having to pay income taxes and a tax penalty. You can avoid paying a tax penalty on your retirement money if you adhere to the Internal Revenue Service's guidelines.
Non-Qualified Withdrawal Penalty
The IRS typically considers your contributions to your 401(k) plan to be deferred compensation. You didn't pay federal income tax on that money, although it's still subject to Social Security and Medicare taxes. Because you didn't pay taxes on the funds going into your 401(k) account, you have to pay taxes on them when they come out. If you withdraw funds from your 401(k) before they become qualified, typically after you reach age 59 1/2, you will owe a tax penalty of 10 percent of the amount withdrawn, in addition to having to pay ordinary income taxes on it.
You can avoid paying ordinary income taxes and the 10 percent tax penalty on your 401(k) money by doing a direct transfer to your IRA. If you don't already have an IRA, you'll need to first set one up with a financial institution such as a bank, mutual fund company, insurance company or investment brokerage. Ask the administrator of your 401(k) to initiate a trustee-to-trustee transfer to your IRA account. This will not involve you taking possession of your retirement funds and won't incur a tax penalty.
If you receive funds from your old 401(k) plan, you have the option of doing a 401(k) to IRA rollover. As long as you contribute an amount equal to your 401(k) distribution into an IRA within 60 days of the original distribution, you won't have to pay income taxes or a tax penalty on the distribution. However, be aware that if the money from your 401(k) is sent to you, your old 401(k) administrator is required to withhold 20 percent of that distribution and send it to the IRS. The IRS considers that 20 percent a taxable distribution. You'll have to come up with another source for an amount equal to the 20 percent withheld, and contribute that amount to your IRA. If you don't, that money will be taxed as ordinary income and will be subject to the 10 percent tax penalty.
The IRS recognizes several exceptions to the non-qualified withdrawal rule. For example, withdrawals made by your estate after your death are not subject to the 10 percent tax penalty. You can take penalty-free withdrawals before age 59 1/2 if you become totally and permanently disabled. If you leave the service of your employer during or after the year you turn 55, you can take penalty-free withdrawals from your 401(k), but not from your IRA.