The IRS sets the rules for 401(k) and other employer-sponsored deferred income plans. Withdrawals from 401(k) plans must follow the rules, or there can be negative tax consequences. The plans do not require a minimum balance before withdrawals are allowed, but if funds are withdrawn early, there will be penalties.
Basics of 401(k) Plans
Many employers offer 401(k) plans as a way for employees to put away some of their wages until retirement. Employee contributions to 401(k) plans are not taxable when made, but the contributions and the accumulated income are taxed when withdrawn in retirement. The size of the 401(k) has no impact on an employee's ability to make withdrawals from the plan. If an employee leaves a job and has less than $5,000 in the 401(k), the employer can transfer it to an individual retirement account for the employee. When the amount is more han $5,000, the employee can choose to leave the funds in the existing plan, or roll them over to a new employer's 401(k) plan, or roll them into an IRA.
Money can be withdrawn from a 401(k) without penalty when the owner turns 59 1/2 years old. If funds are withdrawn before that, there might be a 10 percent penalty on the entire withdrawn amount, and the withdrawal will become taxable income. Some people withdraw funds from their 401(k) plans when they leave an employer, but this can result in taxable income. Rolling the funds directly into a new sheltered plan prevents this taxation. Each financial institution has its own rules and procedures for the transfer.
Borrowing Against a 401(k)
An alternative to withdrawing early from a 401(k) account is to borrow against it. Each plan administrator has different rules for borrowing. In many cases, plan administrators allow borrowing only for financial hardship, but sometimes the criteria are more generous. The loan must be repaid based on the terms of the plan administrator. Otherwise the total amount borrowed will be taxed as if it were a withdrawal, and -- if the borrower is younger than 59 1/2 -- a 10 percent penalty will be applied to the amount borrowed.
Taxation of Withdrawals
Withdrawals from 401(k) plans are taxed in the same way, regardless of the age of the plan holder. The amount withdrawn is taxed as ordinary income. It does not matter whether the withdrawal consists of original contributions, dividends, interest or capital gains. Because the original contributions were tax-deferred, they are fully taxed on withdrawal. If the plan holder was in a higher tax bracket when he made the contribution than he is when he withdraws it -- as is often the case in retirement -- he saves on taxes.
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