401k plans are funded with pretax dollars, which means that you must pay taxes on the money that you withdraw. If you are withdrawing a lump sum amount from your account, you could be in for a big tax bill. Factor in the expected amount of taxes so that you won't have an unpleasant surprise.
20 Percent Withholding
When the custodian of the account gives you a check for the requested lump sum amount, it will withhold 20 percent of the amount for taxes, similar to the way your employer withholds money for taxes. Factor this into your request if you need a specific amount of money for any reason, and are not simply closing out the full account. This withholding is then applied to the taxes that you owe at the end of the year. If you have a low salary, you may receive a refund.
10 Percent Penalty Tax
In addition to the 20 percent withholding, you may also face a 10 percent penalty. This is true for anyone who is under 59 1/2 years old withdrawing money from their own account. However, if you received a 401k as an inheritance, you do not have to pay the penalty when taking a lump sum distribution, although you are still responsible for taxes.
Income Tax Rate
The exact amount of taxes that you'll pay on the lump sum distribution depends on your income level. Any amount that you receive is added to your yearly salary or wages, then taxed at the appropriate level. For example, if you are single filer with a $30,000 a year salary and you received a $100,000 lump sum distribution from an inheritance, you will be taxed at the same rate as someone earning $130,000 for the year, minus any deductions. The amount withheld may or may not be enough to satisfy your tax for the year.
The lower your income, the fewer taxes you pay. Thus, you can minimize the tax burden by taking small lump sum payments over time, rather than one large lump sum payment. Doing this also allows the money to grow in your account.