The Rules of 401K Withdrawals
401K Withdrawal Rules Apply To Four Different Types of Withdrawals
It's pretty clear how and when you can contribute money to your 401K, but what about when you want to cash out your 401K? We've brushed up on the 401K rules and will try to explain them below.
401K Withdrawal Rules
If you got to the IRS website and read the 401k withdrawal rules they seem pretty complicated, however, they're not really that hard to understand. Basically, the 401k withdrawal rules cover four different scenarios, which we'll cover below.
Early 401k Withdrawal
Early withdrawals are taxed as ordinary income in the year that you withdraw. They are also subject to a 10% penalty tax in the year of the early withdrawal. For example, if you withdraw $10,000 you will have to pay federal and state taxes on that ($2,000 - 4,000 depending on your tax rate) and you will have to pay a $1,000 penalty, computed with your tax return. If you are thinking of doing this, please read our section on whether you should take an early 401k withdrawal.
Taking a 401k loan is another type of 401k withdrawal, although technically it is a loan so there are no penalties associated with this transaction. The 401k withdrawal rules allow you to withdraw a portion of your 401k for up to 5 years (longer if it is to buy a primary residence), at a "reasonable" rate of interest. All other provisions of a 401k loan, including whether or not they are allowed, are dictated by your 401k plan. And if you leave your employer during the loan period, you will almost always be required to pay back the loan immediately, or face penalties.
One other interesting rulet about a 401k loan is that the interest paid on the loan goes back into your account. So instead of paying a bank the interest, you are actually paying yourself.
Voluntary 401k Withdrawal Rules
The rules here are simple. Once you turn 59 1/2, you can withdraw as much or as little as you like each year from your 401k. When you turn 70 1/2 or retire (whichever is later), you will have to make mandatory minimum withdrawals (see next section). Withdrawals will be taxed as ordinary income on your tax return.
Mandatory 401k Withdrawal Rules
If you haven't needed the money from your account and you turn 70 1/2 or retire (whichever is later), you will need to start making minimum withdrawals each year, also called required minimum distributions (RMDs). You can calculate these by filling out the RMD worksheet at the IRS. If you have been making withdrawals before 70 1/2, make sure that you fill out the RMD worksheet to make sure that you are withdrawing more than the minimum amount. All of these withdrawals will be taxed as ordinary income on your annual tax return.
See Also: Other 401k advice