Understanding the tax implications of withdrawing funds from your 401k is crucial for retirement planning. The amount of tax on 401k distribution depends on several factors, including your age, the type of distribution, and whether you roll over the funds. This guide provides detailed information on 401k distributions and their associated taxes.
Understanding 401(k) Distribution Rules
Generally, you can’t access your 401(k) funds until certain events occur:
- Death, disability, or severance from employment
- Plan termination without a successor defined contribution plan
- Reaching age 59½
- Experiencing a financial hardship
Distributions can be nonperiodic (lump-sum) or periodic (annuity or installment payments), depending on the plan’s terms.
For balances exceeding $5,000, plan administrators typically require your consent before distributing funds. Some plans may also require spousal consent. If a distribution exceeds $1,000 and you don’t elect to receive it directly or roll it over, the plan administrator will transfer it to an individual retirement plan of a designated trustee or issuer, notifying you of the transfer option.
Distributions from your 401(k) are generally taxable unless rolled over. If you were born before 1936 and receive a lump-sum distribution, you might be eligible for optional tax calculation methods, detailed in Publication 575, Pension and Annuity Income, and Form 4972 Instructions PDF, Tax on Lump-Sum Distributions.
Required Minimum Distributions (RMDs)
A 401(k) plan must ensure you receive your entire interest in the plan by your required beginning date or begin receiving regular distributions calculated to distribute your entire interest over your life expectancy (or a shorter period). These rules apply individually to each qualified plan.
The plan administrator determines the minimum amount you must withdraw annually. Refer to Publication 575 for guidance on calculating this amount.
The required beginning date is April 1 of the year after the later of:
- The calendar year you reach age 72 (70 ½ if you reached 70 ½ before January 1, 2020)
- The calendar year you retire
However, a plan might require distributions to begin by April 1 of the year after you reach age 72 (or 70 ½), even if you haven’t retired. If you’re a 5% owner of the employer, you must begin receiving distributions by April 1 of the year after you reach age 72 (or 70 ½).
The distribution required by April 1 is for the starting year. Subsequent distributions must be received by December 31 of each year. If no distribution occurs in the starting year, you must take two distributions the following year (one by April 1 and one by December 31). Publication 575 provides information on distributions after a participant’s death.
Navigating Hardship Distributions
A 401(k) plan may permit hardship distributions for immediate and heavy financial needs. The Bipartisan Budget Act of 2018 brought changes to these rules, with the IRS releasing proposed regulations to implement them. These changes generally relax restrictions on taking hardship distributions.
Previously, hardship distributions were limited to elective deferrals and generally excluded income earned on those amounts. The proposed regulations allow plans to permit hardship distributions of elective contributions, QNECS, QMACS, safe harbor contributions, and earnings on these amounts, regardless of when contributed or earned, starting January 1, 2019. Hardship distributions cannot be rolled over.
A distribution qualifies as a hardship distribution only if it’s due to an immediate and heavy financial need and is necessary to satisfy that need. This determination must adhere to nondiscriminatory and objective standards outlined in the plan.
The distributable amount equals your total elective deferrals as of the distribution date, minus previous distributions of elective contributions.
Immediate and Heavy Financial Need: This is determined based on all relevant facts and circumstances. Examples include:
- Medical expenses for you, your spouse, or dependents
- Costs directly related to purchasing a principal residence (excluding mortgage payments)
- Tuition, related educational fees, and room and board for the next 12 months of postsecondary education for you, your spouse, children, or dependents
- Payments to prevent eviction or foreclosure
- Funeral expenses
- Certain expenses for repairing damage to your principal residence
The amount of an immediate and heavy financial need may include amounts to pay federal, state, or local income taxes or penalties resulting from the distribution.
A distribution is deemed necessary if the employer relies on your written representation that the need cannot be relieved through insurance reimbursement, asset liquidation, cessation of contributions, other distributions or loans from plans, or borrowing from commercial sources, unless the employer has actual knowledge to the contrary.
A distribution is deemed necessary if it doesn’t exceed the financial need amount, you’ve obtained all other available distributions under the plan and other employer-maintained plans (with the option to exclude the requirement to first obtain a plan loan), and you’re prohibited from making elective contributions for at least 6 months after the distribution (this suspension is optional starting January 1, 2019, and not allowed from January 1, 2020).
If hardship distributions haven’t followed your plan or the rules, correct the mistake as detailed in the 401(k) Plan fix-it guide.
Understanding Rollovers from Your 401(k)
A rollover involves receiving a distribution from a qualified retirement plan and contributing it within 60 days to another qualified retirement plan or traditional IRA. This transaction is not taxable but is reportable on Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. PDF and your federal tax return.
Most distributions can be rolled over, except:
- Payments based on life expectancy or over ten years
- Required minimum distributions
- Corrective distributions
- Hardship distributions
- Dividends on employer securities
Any non-rolled-over taxable amount must be included in your income for the year received. You have 60 days from the distribution date to roll it over. Taxable distributions are subject to mandatory 20% withholding, even if you plan to roll them over. To defer tax on the entire taxable portion, you’ll need to add funds equal to the withheld amount from other sources.
Alternatively, you can have your 401(k) plan directly transfer the distribution to another eligible plan or IRA, avoiding withholding. If you’re under 59 ½, any non-rolled-over taxable portion may be subject to a 10% additional tax on early distributions.
For more information, refer to Publication 575 and Publication 560, Retirement Plans for Small Business (SEP, SIMPLE, and Qualified Plans).
Tax Implications of Early Distributions
Distributions before age 59½ may incur a 10% additional tax on the amount included in income.
Exceptions: The 10% tax doesn’t apply in certain situations:
- Distributions to a beneficiary (or estate) after the participant’s death
- Distributions due to the participant’s qualifying disability
- Substantially equal periodic payments beginning after separation from service, made at least annually for life or life expectancy
- Distributions after separation from service during or after the year the participant reached age 55
- Distributions to an alternate payee under a qualified domestic relations order (QDRO)
- Distributions for medical care up to the allowable medical expense deduction
- Timely reductions of excess contributions, employee/matching contributions, or elective deferrals
- Distributions due to an IRS levy on the plan
- Distributions related to certain disasters
To report the tax on early distributions, you may need to file Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts PDF.
Loans from 401(k) Plans: Tax Implications
Some 401(k) plans allow participants to borrow from the plan, as specified in the plan document. A loan is not taxable if it meets certain criteria.
Generally, you can borrow up to 50% of your vested account balance, up to a maximum of $50,000. The loan must be repaid within 5 years, unless used to buy your main home, with substantially level payments made at least quarterly.
Reduce the $50,000 amount if you had an outstanding loan from the plan (or any other plan of your employer) during the 1-year period before the new loan. The reduction is your highest outstanding loan balance during that period minus the outstanding balance on the new loan date.
Certain participant loans may be treated as taxable distributions. See “Loans Treated as Distributions” in Publication 575.
If loans exceed limits or don’t follow plan terms, correct the mistake as detailed in the 401(k) Plan Fix It Guide.
Before borrowing from your 401(k), consider other loan sources, as borrowing may negatively impact your account’s earnings and reduce your retirement savings.
Conclusion
Understanding the tax implications of 401k distributions is essential for effective retirement planning. Factors like age, distribution type, and rollover options significantly impact the amount of tax you’ll owe. By carefully considering these factors and consulting with a financial advisor, you can make informed decisions about your 401k distributions and minimize your tax liability.
