If you take a 401k withdrawal and the money in the 401k was deducted from your taxable income, you’ll be taxed on the funds you withdraw. Depending on the circumstances, you may also be subject to a penalty. There’s a lot of confusion about how the taxation works – and the taxation and penalties can be different depending upon the circumstances.
Taxation of the 401k Withdrawal
When you take a distribution of pre-tax money from a 401k plan, the amount of the 401k withdrawal that is pre-tax will be included in your income and will be taxed at your marginal income tax rate in that year.
Unless you meet one of the exceptions noted in the article 16 Ways to Withdraw Money From Your 401k Without Penalty, your 401k withdrawal will also be subject to a 10% early withdrawal penalty.
For example – if you have a 401k plan at a former employer and you are 45 years of age, unless your 401k withdrawal meets one of the exceptions, taxation would work like this for a $50,000 401k withdrawal:
|Taxable Income before withdrawal||$60,000|
|Tax (assumes MFJ)||$8,072.50|
|Effective Tax Rate||13.45%|
|Other taxable income||$60,000|
|Total taxable income||$110,000|
|Tax (assumes MFJ)||$23,836.75|
|Effective Tax Rate||21.67%|
|Total Tax and Penalty||$28,836.75|
|Total Effective Tax Rate||26.22%|
Nothing really dramatic about the first part, it’s just more taxable income and you’ve likely grown to understand the effect of the graduated tax schedule. But what will likely open your eyes is the fact that this $50,000 was actually taxed at a rate of 41.53%! Your 401k withdrawal of $50,000 resulted in $20,764.25 in taxes and penalties, so in effect you only “net” $29.235.75 from this withdrawal. Almost makes a payday loan look cheap by comparison.
On the other hand, if you met one of the exceptions (such as being age 59½ or older, the penalty would not apply. The effective tax rate on the 401k withdrawal is 10% less, at only 31.53%.
Another thing you need to understand about your 401k withdrawal is the mandatory withholding. Unless your 401k withdrawal is a direct rollover to another plan (such as an IRA), part of a Series of Substantially Equal Periodic Payments (SOSEPP, or 72t option), is a Required Minimum Distribution or a hardship distribution, there is a requirement for the administrator to withhold 20% from the 401k withdrawal.
This 20% is sent to the IRS and will be included as part of your withholding and estimated tax payments that will apply against your tax when you file. If the withholding was too much, you’ll get a refund of the extra withholding, just as you do from extra withholding or estimated payments.
Here’s a continuation of the previous example to illustrate withholding:
|Mandatory Withholding (20%)||$10,000|
|Other Withholding (from W4 wages)||$9,000|
|Total Tax and Penalty (from prior)||$28,836.75|
|Amount You Owe||$9,836.75|
As you can see, even though the mandatory withholding from the 401k withdrawal is substantial, it’s not enough in many cases to cover the tax and penalties from the withdrawal.