A 401(k) retirement plan allows an employer and employee both to contribute to the employee’s retirement fund. The idea is to encourage employees to save for their retirement by deferring taxes on retirement contributions and earnings until the employee reaches retirement age. To discourage withdrawals prior to retirement, 401(k) plans must impose a stiff penalty tax on such early withdrawals.
The Internal Revenue Service (IRS) deems you to be retired if you are age 59 ½ or older. This is the age at which you can start withdrawing funds from your 401(k) without penalties, although you will owe income taxes on your withdrawn amount. You can withdraw funds from your 401(k) early, before age 59 ½, but you must pay a penalty tax equal to 10 percent of the withdrawn amount plus income taxes on the withdrawal. In addition, the 401(k) administrator must withhold 20 percent of an early withdrawal for federal taxes.
If you are facing an immediate and heavy financial hardship, you can take an early withdrawal from a 401(k) plan without incurring the 10-percent tax penalty. You still will owe income tax on the money. Hardships include medical expenses exceeding 7.5 percent of your income, a down payment on your first home, college tuition and related expenses, payments to prevent foreclosure or eviction from your home, payments to repair major damage to your home from fire or weather, funeral expenses, if you become disabled, payments to an ex-spouse under a separation or divorce decree, or if you are over age 55 when you are separated from your employer’s service.
Many 401(k) plans permit you to borrow from your account. Loans from your 401(k) plan are not taxable, but must meet certain criteria. Loans cannot exceed the lesser of 50 percent of your vested account balance or $50,000. Loans must be repaid within five years. The loan must be repaid in substantially equal payments made at least quarterly. You will have to pay interest on your 401(k) loan, set according to prevailing market rates. But you are paying the interest back to yourself. If you default on your loan, the remaining balance becomes a taxable distribution.
If you are discharged from your employer’s service, you will have the option of leaving your 401(k) with your former employer or rolling the account over into another 401(k) or into your own individual retirement arrangement (IRA). There are no tax consequences if you leave the funds in place. A direct rollover into another 401(k) plan or an IRA is a tax-free transaction. If you do an indirect rollover, where the funds are paid to you and you later pay them into another tax-deferred retirement account, your former employer must withhold 20 percent of your distribution. You must put the remainder into another retirement account within 60 days. You will owe income tax and a 10-percent penalty tax on the amount withheld unless you replace the withheld money from some other source within the 60-day rollover window.
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