Named after a section in the Internal Revenue Service tax code, 401(k) retirement plans first became popular with large companies in the 1980s. According to the American Benefits Council, the 401(k) has grown to become the most popular employer-sponsored defined contribution retirement plan in the United States. For many people, tax-deferred contributions and the option to withdraw money to cover a financial emergency are among its most attractive features. Because it's a tax-deferred plan, the IRS does not collect income tax on contributions until you make a withdrawal. The amount due depends on when you make a withdrawal.
How a 401(k) Works
With a 401(k) plan, you decide how much to contribute each pay period, up to the current contribution limit, and how to invest it according to the options the plan provides. Although many employers match a percentage of your contribution, there is no requirement that they do so. While some plans do not allow you to withdraw funds until you reach 59½ years of age, an employer has the option to allow you to withdraw money early. Income tax is always due in the year you make a withdrawal. In most cases, the IRS will also impose a penalty fee if you withdraw money early.
Required Minimum Distribution at Retirement Age
Although you can begin withdrawing money at age 59½, you must start taking at least the required minimum distribution, or RMD, when you reach 70½ years of age. An RMD calculation for each year involves dividing the prior Dec. 31 balance of your 401(k) by a life expectancy factor found in tables the IRS publishes in Appendix B of Publication 590-B, Distributions From Individual Retirement Arrangements, or IRAs. If you do not take a required distribution, the IRS will tax the amount you do not withdraw at 50 percent.
Withdrawal Tax Rules and Forms
Tax rules say that a 401(k) withdrawal is taxable income whether it is a required distribution or an early withdrawal. While you have the option to file your taxes using Form 1040 or Form 1040A if you took a required distribution, you have to use Form 1040 and attach Form 5329 and the Form 1099-R you received from your employer if you took an early distribution. The amount of tax you pay depends on your filing status, current tax rate and total income. In most cases, you will also pay a 10 percent penalty fee if you took an early withdrawal.
IRS Publication 509-B lists a number of exceptions to the 10 percent early withdrawal penalty. While you are responsible for paying income tax, the penalty fee will not apply if you take an early withdrawal for any of these reasons. For example, the penalty fee will not apply to an early withdrawal made to you if you became totally and permanently disabled or to your beneficiaries if you die. An early withdrawal to pay medical expenses that exceed 10 percent of your gross income also qualifies as an exception.