A 401(k) is a type of retirement plan that is typically put in place by an employer for the employees of the company. The plan allows participants to save before-tax dollars in a special account that is intended to be left in place until the employee retires. Since a 401(k) is a long-term plan, there are significant penalties if a person takes money from his account prior to reaching retirement age, though there are some exceptions to this rule.
The earliest age at which a person normally receives a regular distribution from her 401(k) plan occurs when she reaches age 59 1/2. At this time, she can begin receiving regular payments from the plan or a single lump sum containing all of the funds she has vested in the plan, which includes both money she has contributed and any matching funds from the employer to which she is entitled. Although the details depend on the specifics of the plan in which she is enrolled, most often the retiree will receive regular payments each month or each year. The money is taxed as regular income at the time it is received.
Funds that are paid out prior to the account owner reaching the age of 59 1/2 are subject not only to regular income tax but also to a 10 percent excise tax. When the money is distributed, 20 percent is withheld for taxes, plus an additional 10 percent for the excise tax. In some situations, the penalty can be avoided, such as when funds are withdrawn for certain hardship situations, the employee has become disabled, the money is being paid to heirs of the employee after his death or he is at least 55 and is retiring early -- a designation with complicated rules. Income tax is still due on these funds.
An employee can choose to remove all of his funds from his 401(k) if he is no longer employed where the plan is located, but she will be subject to the same taxes and penalties as for any other early distribution situation unless she opts to roll over all of the funds from her 401(k) to a new retirement plan. In this case she does not have to pay either taxes or penalties, but her money will still be subject to withholding unless she has the trustee of the first 401(k) deposit the money directly into another qualified retirement plan. There is no withholding requirement in the case of a direct transfer.
It is often possible to borrow from a 401(k) plan, if the plan allows it. In this case, no taxes are due as long as the borrower takes no more than 50 percent of the amount he has vested in the plan, with a maximum limit of $50,000. He must pay it back within five years by making regular, equal payments. If the employee leaves the company, the loan is typically due immediately.