To encourage people to use their 401(k) plans for retirement rather than raiding them early, the Internal Revenue Service sets specific criteria for taking distributions. Depending on whether you have a traditional 401(k) plan or a Roth 401(k) plan, you may not be able to ever take completely tax-free distributions. But you can at least avoid early withdrawal penalties.
Traditional 401(k) Distributions
Distributions from a traditional 401(k) plan are never tax-free, at least from federal income taxes, because the contributions you made to the 401(k) plan were excluded from your taxable income at the time. So, when you take money out, you have to pay taxes on the withdrawals. However, depending on where you live, you may not have to pay state income taxes. For example, Illinois doesn't tax 401(k) distributions, and Georgia, Montana and New Jersey have exemptions that could reduce the amount of your distributions on which you must pay taxes.
Roth 401(k) Distributions
Roth 401(k) plans, on the other hand, do offer tax-free withdrawals because your contributions weren't excluded from your taxable income at the time. For your withdrawals to be completely tax-free, you must be at least 59 1/2 and you must have had your Roth 401(k) plan open for at least five years, according to the IRS. If you take distributions before you meet both criteria, the withdrawals will be prorated between your contributions to the account, which do come out tax-free, and your earnings, which are taxable income. For example, if your Roth 401(k) has $40,000 of contributions and $10,000 of earnings, 20 percent of the distribution is taxable.
Both traditional and Roth 401(k) plans impose a 10 percent penalty on the taxable portion of distributions taken before age 59 1/2 unless an exception applies. For example, if you take out $12,000 from your traditional 401(k) and include the entire amount as taxable income, you pay an extra $1,200 penalty. If you have a Roth 401(k) and your $12,000 distribution is split between $9,600 of contributions and $2,400 of earnings, you'll pay the penalty only on the $2,400 of earnings, for a total penalty of $240.
The IRS does waive the early withdrawal penalty if you qualify for one of the exceptions. For example, you can take out as much as you want, penalty-free, if you're permanently disabled, taking withdrawals as a qualified reservist called to active duty or withdrawing money as a beneficiary of an inherited 401(k). You can also take out the amount needed to pay your medical costs in excess of 10 percent of your adjusted gross income or to satisfy an IRS levy on your 401(k) plan. However, the IRS does not have a general exception for "hardships," even if you qualify for a hardship distribution from your 401(k) plan. In addition, none of these exceptions excuse you from paying income taxes on the distributions.