Whether you are changing jobs or you are ready to retire, it is important to understand when you can take your savings out of the 401k and how you will be taxed.
Your Summary Plan Description will list the distribution rules that apply to your plan, but here are some of the most frequently asked questions – and answers – you need to know to make the most of the tax advantages you earn for saving in a 401k plan.
If you are eligible to take a distribution of your 401k savings, you have four options:
Although taking a cash distribution can be tempting, this option can have high tax consequences now and be a long-lasting drain on your future retirement income.
Be sure you understand the potential pros and cons of each option before you make your choice.
You generally cannot take your money out of a 401k unless you have had a “distribution event” such as:
Each plan will have a list of “distribution events.
Your 401k plan may allow you to access your savings while you are still working and before you have a “distribution event.” The two most common ways to access your account before retirement are by taking a loan from your 401k account, which you will have to pay back, or by taking a distribution because you have a financial hardship.
Most 401ks allow distributions for the following types of financial hardships:
You will be required to provide documentation to prove your hardship and the dollar amount needed. Hardship distributions are taxable if you distribute pre-tax savings. If you are younger than age 59½, you will also owe a 10% early distribution tax unless you meet an exception.
The 10% early distribution tax, sometimes called a penalty, is waived if you are:
If you have a distribution event, you can take your entire vested account balance out of the plan (called a lump sum distribution). Some plans allow partial payouts or installment payments, such as a specific dollar amount each year or each quarter. Some plans allow you to convert your retirement savings to an annuity, which is designed to pay out your account balance in a steady stream of payments over your lifetime.
“Vesting” means ownership. You are always 100% vested in the salary deferral contributions you make to a 401k, but employers may assign a vesting schedule to the contributions they make to the plan (matching or profit sharing contributions). A vesting schedule requires you to work for the employer for a period of time before owning 100% of the employer contributions made to your account. A vesting schedule can be as long as six years. If you leave the employer before becoming 100% vested, the unvested portion of your account will be forfeited.
If you are taking a cash payment and not rolling over any of the distribution, the tax impact will depend on two factors: the types of contributions you or your employer made to your account and your age.
If your 401k account holds only contributions that were deducted from your paycheck before income taxes were withheld, contributions made by your employer, and investment earnings, you must include the full amount of distribution in your taxable income in the year you take the distribution.
If you made Roth contributions to your 401k plan, you would not be taxed on the amount of the Roth contributions you take out of the plan since you paid taxes before putting the dollars into the plan. The earnings portion of your Roth 401k distribution will also be tax-free if the distribution is “qualified.” To take a qualified distribution, you must have had a Roth account for at least five years, and the distribution is taken after you reach age 59½, die, or become disabled. If you take a “nonqualified” distribution, you must include the earnings portion of the distribution in your taxable income in the year you take the distribution.
If you are younger than age 59½ when you take a distribution, and you do not meet one of the early distribution exceptions, you will owe an additional 10% tax on your distribution. Additionally, your 401k administrator generally must withhold 20% of your taxable distribution.
If your 401k distribution was eligible to be rolled to another 401k or an IRA, but you choose to take it in cash instead, 20% of the taxable amount distributed must be withheld and sent to the IRS as a pre-payment of the income tax you owe on the distribution. This means that you will receive 20% less than the full distribution amount.
Some types of distributions are not eligible to be rolled over, such as distributions you are required to take beginning at age 70½. If a distribution is not eligible to be rolled over, it is subject to a lesser rate of withholding, and you may elect to waive that withholding.
There are two situations in which you can be forced to take money out of a 401k:
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