Monday, February 06, 2012

• When can I take money out of my 401(k) account?
• What is the penalty if I take money out of my 401(k) before I'm 59 1/2?
• How is the 10% penalty tax calculated?
• What if I need the money in an emergency - Can I take out a loan?
• Under what circumstances can an individual begin to receive distributions from a 401(k) or qualified savings plan before age 59 1/2?
• When am I required to start withdrawing money from my
  401(k) account? When do I have to close it?
• Is it a good idea to take out a loan on my 401(k)?

When can I take money out of my 401(k) account?

You should check with your company's Human Resources or Benefits representative regarding the rules for your specific plan. Below is general information about some situations in which distributions are permitted, and the related penalties and tax implications for each.

• Once you reach age 59 ½, you can generally begin to withdraw money from your 401(k) with no penalty. Federal, state and local income taxes are due on the amount you withdraw.
• If you withdraw money before age 59 ½ under the following circumstances, you may not have to pay the 10% penalty, depending on the rules of your 401(k) plan:
  
  A. If you become totally disabled.
  
  B. If you die, and your beneficiary collects the money.
  
  C. If you are in debt for medical expenses that exceed 7.5% of your adjusted gross income.
  
  D. If you are required by court order to give the money to your divorced spouse, a child, or a dependent.
  
  E. If you are separated from service (through permanent layoff, termination, quitting or taking early retirement) and you're at least 55 years old.
  
  F. If you are separated from service and you have set up a payment schedule to withdraw money in substantially equal amounts over the course of your life expectancy. (Once you begin taking this kind of distribution you are required to continue for 5 years or until you reach age 59 ½, whichever is longer.)
  
  Any money withdrawn for the above reasons would still be subject to applicable federal, state and local income taxes.
• You may qualify for a "financial hardship" withdrawal if you need the money: A) to pay college tuition for yourself or a dependent, provided it's due within the next 12 months; B) to make a down payment on a primary residence; C) to pay unreimbursed medical expenses for you or your dependents; or D) to prevent foreclosure or eviction from your home. While distributions are generally allowed for those reasons, you may still have to pay the 10% premature distribution penalty unless you can prove you are in truly dire straits. All applicable federal, state and local income taxes are also due on the amount you withdraw.

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What is the penalty if I take money out of my 401(k) before I'm 59 1/2?

The penalty is generally 10% of the untaxed money you withdraw (pre-tax contributions and any earned interest). You must also pay any applicable federal, state and local taxes on that amount. So if you were to withdraw $5,000 from your 401(k) before age 59 ½, you would owe a penalty of $500, plus federal, state and local taxes on the entire $5,000.

For exceptions to this rule, see: "Under what circumstances can an individual begin to receive distributions from a 401(k) or qualified savings plan before age 59 ½?"

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How is the 10% penalty tax calculated?

The 10% penalty applies to the entire untaxed amount that you withdraw. If you withdrew $5,000 from your 401(k) before you were 59 ½, you would owe a penalty of $500, plus applicable federal, state and local taxes on the entire $5,000.

If you've made after-tax contributions to your 401(k), it gets a bit more complicated. You do not have to pay the 10% penalty or any additional taxes on the amount of your after-tax contributions. You do, however, have to pay the 10% penalty and all taxes due on any interest earned and employer-matching contributions made as a result of your after-tax contributions.

If you're thinking "I'll just take out my after-tax contributions and leave the earnings where they are" – nice try, but no dice. For every after-tax contribution dollar you withdraw, the IRS requires you to withdraw a proportional amount of the earnings, too.

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Under what circumstances can an individual begin to receive distributions from a 401(k) or qualified savings plan before age 59 1/2?

You should check with your company's Human Resources or Benefits representative regarding the rules for your specific plan. Below are some general situations where distributions are permitted, and the related penalties and tax implications for each.

Under the following circumstances, you might not have to pay the 10% penalty, depending on the rules of your 401(k) plan:

• If you become totally disabled.
• If you die, and your beneficiary collects the money.
• If you are in debt for medical expenses that exceed 7.5% of your adjusted gross income.
• If you are required by court order to give the money to your divorced spouse, a child, or a dependent.
• If you are separated from service (through permanent layoff, termination, quitting or taking early retirement) and you're at least 55 years old.
• If you are separated from service and you have set up a payment schedule to withdraw money in substantially equal amounts over the course of your life expectancy. (Once you begin taking this kind of distribution you are required to continue for 5 years or until you reach age 59 _, whichever is longer.)

Any money withdrawn for the above reasons would still be subject to applicable federal, state and local income taxes.

You may qualify for a "financial hardship" withdrawal if you need the money: 1) to pay college tuition for yourself or a dependent, provided it's due within the next 12 months; 2) to make a down payment on a primary residence; 3) to pay unreimbursed medical expenses for you or your dependents; or 4) to prevent foreclosure or eviction from your home. While distributions are generally allowed for those reasons, you may still have to pay the 10% premature distribution penalty unless you can prove you are in truly dire straits. All applicable federal, state and local income taxes are also due on the amount you withdraw.

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When am I required to start withdrawing money from my 401(k) account? When do I have to close it?

You must begin taking distributions from your 401(k) plan by April 1 of the calendar year following the calendar year in which you turn 70 ½. Otherwise you will be liable for a penalty of up to 50% of what you should have taken out, but didn't. An exception is made if, at age 70 ½, you are still working for the employer who sponsors your 401(k) plan. In that case you are required to start taking distributions by April 1 of the calendar year following the year in which you retire.

Once you retire, you have the option of leaving your account with your former employer, providing there is more than $5,000 in it. There is no requirement for you to close the account as long as your former employer continues to sponsor it.

If for some reason your former employer were to stop sponsoring the 401(k) plan, you could either take a lump sum distribution or roll the account over into a rollover IRA. If you took a lump sum distribution you would have to pay tax on the entire amount, but you might be able to spread it over 5 or 10 years. If you rolled the money over into an IRA you would not have to pay taxes until you withdrew the money.

It would be a good idea to contact the appropriate tax/estate planning and investment professionals for advice in this situation.

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Is it a good idea to take out a loan on my 401(k)?

This depends on your particular situation and 401(k) plan. As a general rule, it is advisable to investigate other loan sources (bank, mortgage company, tuition loans from schools or government) before dipping into your 401(k).

Different 401(k) plans have different rules. Some do not allow loans, while others may only allow them in certain cases. You should check with your HR or benefits department to find out whether your plan allows loans, and under what circumstances.

If loans are permitted, they are generally limited to $50,000 or half of the value of your account (your contributions and vested employer match contributions) whichever is smaller. There might also be a minimum amount imposed by your company. Repayments of loan principal and interest are deducted directly from your paycheck after taxes and deposited in your 401(k) account. You generally have to pay the loan back within five years, unless it is used for the purchase of a primary residence, in which case you may have longer.

While it may seem like a good idea to borrow from yourself, there are actually some big disadvantages.

• The money you withdraw no longer earns compound interest, so your overall account will be much smaller when you retire, especially if you also stop making contributions while you are paying off your loan.
• You will be taxed twice on the money you use to pay back the loan: once when you get your paycheck, and again when you eventually withdraw money from your 401(k) account after retirement.
• If you quit your job, or are fired, you will probably have to pay back the full amount of the loan right away (and just when you probably need the most). If you don't - if you default on the loan - it will be treated as an early distribution from your plan and you will have a hefty bill on your next tax return - federal, state and local taxes on the entire amount, plus most likely a 10% penalty if you are under 59 ½.
• When your loan payments are deposited directly into the account they don't necessarily go back into the funds they were taken out of, so you have to be sure to rebalance your portfolio to keep your investment strategy on track.

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