There are several types of distribution options for 401(k) plans. These include lump sum distributions, periodic distributions and required minimum distributions.
If you change jobs but do not wish to withdraw the funds in your 401(k), you are eligible to transfer your 401(k) funds to a new, IRS approved account. This is known as a rollover. Each distribution method has its own set of eligibility requirements and tax penalties.
Lump Sum Distributions
You can withdraw all of the funds in your 401(k) account at any time. This is known as a lump sum distribution, and it is subject to various tax penalties based on your age.
If you choose to take a lump sum distribution of your funds and you are under the age of 59 1/2 you will be expected to pay the IRS 30% of the total amount available in your 401(k) account. That includes a 20% withholding tax, and a 10% early withdrawal penalty.
If you are older than 59 1/2, you will need to pay the IRS the 20% withholding tax, but you get to skip the additional early withdrawal fee.
Once you reach the IRS approved retirement age of 59 1/2, you can choose to withdraw money from your 401(k) in a series of periodic payments. The amount and frequency of the payments are decided by you, and the financial company that manages your 401(k) account on behalf of your employer.
If you choose to schedule your withdrawals, then you will not have to pay the 20% withholding tax that is levied on lump-sum payments. Your 401(k) distributions will be treated as income for tax purposes and you will be taxed according to the tax and income bracket that you qualify for.
Required Minimum Distributions
Once you reach the age of 70 1/2 the IRS requires that you begin taking distributions from your 401(k) account if you have not already done so. These payments are known as required minimum distributions.
The amount that you are required to withdraw depends on the amount of money in your 401(k) account and your life expectancy. The financial company that handles your 401(k) account will use the information available from the IRS to ensure that you are withdrawing the correct amount of money each year.
Taxes on required minimum distributions are factored the same way as periodic payments; they are treated as income and subject to your normal income tax bracket.
In some cases you may qualify to make a hardship withdrawal from your 401(k) account. The IRS has detailed rules for hardship withdrawals, and your 401(k) plan may have additional requirements.
Specific reasons people make hardship withdrawals from their 401(k) accounts include the desire to pay off overwhelming medical debt, to purchase a home, to pay school tuition, or to handle funeral expenses.
Hardship withdrawals may be taxed the standard 10 percent early withdrawal fee by the IRS if you are under the age of 59 1/2. If your 401(k) plan offers the option, then taking out a 401(k) loan is usually more beneficial from a tax standpoint.
If your employer's 401(k) plan allows you to do it, you may be able to lend yourself money directly from your 401(k) account balance.
401(k) loans usually need to be repaid within 5 years, but the money that you withdraw is tax free. Most 401(k) plans that allow loans will let you withdraw up to 50% of your total account balance, or up to $50,000 total. Your individual plan may vary though, so it is best to check with your company to get the specific details.
You may be able to avoid paying early withdrawal penalties on your 401(k) if you become permanently disabled, or if you are the beneficiary of a person who has passed away. For more information on avoiding early withdrawal penalties you should consult a financial adviser.
If you have recently moved to a new job and you want to transfer the funds in your 401(k) account to your new employer, you may do this without paying taxes. This is known as a 401(k) rollover. You will need to contact the financial company that handles your new employer's 401(k) plan. They will help you take care of transferring your funds without incurring IRS penalties.