401(k) plans allow you to contribute part of your wages each pay period to an employer-sponsored retirement savings program. You may allocate the money in your account into investments such as bonds, stocks, money market funds and mutual funds. The money contributed to the plan and any increase in value are not taxable until you withdraw funds from your account. Activity in a 401(k) plan impacts your tax return in several areas.
Reporting a Distribution
You must file your taxes on Form 1040 or 1040A if you received a 401(k) plan distribution at any time during the tax year. This applies to all types of distributions, even hardship withdrawals and rollovers. Hardship withdrawals are considered taxable distributions for the year in which you withdraw the money. You will receive Form 1099-R from your plan administrator prior to Jan. 31 of the year following the distribution. The 1099-R form reports the amounts of any taxable and non-taxable distributions, along with the type of distribution.
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Early Withdrawal Penalty
If you are younger than 59 1/2 when you receive your distribution, you will be required to pay a 10 percent early withdrawal penalty in addition to any income taxes you may owe. The penalty is assessed on your tax return, not withheld from the distribution. Save money for the added penalty so you do not get an unpleasant surprise when it comes time to pay your taxes. If you are requesting a partial distribution from your 401(k) plan, add the amount of the expected penalty to your distribution request so you have enough money to cover the tax burden.
Taxation of Rollovers
You can avoid tax liability by rolling over your distribution to another qualified retirement plan or an individual retirement account. Rollovers are reported on Form 1099-R even though there is no tax liability. The taxable amount listed in Box 2a should be zero and the distribution code in Box 7 should be "G." Contact the plan administrator immediately if either one of these items is incorrect. The wrong code may trigger a taxable distribution that will take time and effort to correct retroactively.
Some 401(k) plans allow you to borrow money from your account and repay it over time through payroll deduction. The amount of the loan is not taxable while you are making regular payments. However, if you default on the loan, the entire outstanding balance will be considered a taxable distribution. The 10 percent early withdrawal penalty also applies to 401(k) loans in default.