Looking to make an early withdrawal from your 401(k)? Before you jump the gun, take a look at some of the tax penalties you may face and how you can reduce your 401(k) taxes.
What is a Traditional 401(k)
First, let’s define what a 401(k) is. A 401(k) retirement plan allows employees to contribute a portion of their paycheck to their long-term individual accounts. These contributions are deducted from gross income, which means the money is taken out from your paycheck before income taxes have been deducted, helping to lower your current income tax bill.
Many employers offer to match a portion of what you save. They will either do a partial matching or dollar-for-dollar. For example, your employer matches half of whatever you contribute but no more than 3% of your salary with partial matching. With a dollar-for-dollar match, your employer puts in the same amount of money you do (up to a certain amount).
What is a Roth 401(k)?
The main difference between a traditional and a Roth 401(k) is when you pay the taxes.
A Roth 401(k) is funded using post-tax income, which means your contributions won’t lower your adjusted gross income. Withdrawals of contributions and earnings are not taxed if the account has been held for at least five years and the distribution is due to disability or death or on or after age 59½.
What are the Penalties of Withdrawing From Your 401(k)?
Withdrawing from your 401(k) before 59 ½ should be your very last resort, as you will face tax penalties and long-term consequences. Not only will the IRS assess a 10% penalty when you file your tax return, but you’ll also have less money when you retire and miss out on the power of compounding. The IRS will also require automatic withholding of 20% of a 401(k) early withdrawal for taxes. For example, if you withdraw the $10,000 in your 401(k), you may get only about $8,000.
How to Reduce Your 401(k) Taxes
The best wait to prevent tax penalties is to avoid dipping into your 401(k) account altogether. If you need to make an early withdrawal, look to see if you qualify for an exception to help you avoid paying penalties. Some exceptions include distributions made to beneficiaries of plans inherited after death, medical expenses, and disability. You can also look into borrowing from your 401(k) instead of making an early withdrawal. However, keep in mind that not all 401(k) plans offer loans, and in most cases, you’ll need to repay the loan within five years.
If you choose to roll your 401(k) account into a new 401(k) or IRA, be aware of the potential tax implications. Make sure to ask for a direct rollover, which means the 401(k) plan administrator will transfer the funds directly to your new tax-deferred retirement account, not to you personally. If you do an indirect rollover, the plan administrator may withhold 20% from your check to pay taxes on your distribution. To avoid paying income tax and a hefty tax penalty, you must deposit the funds into the new account within 60 days.
Speak to a Tax Professional at US Tax Shield
If you would like help determining which course to take to minimize your 401(k) taxes, we recommend speaking to a tax professional. Only a qualified tax attorney from a reputable tax relief company is authorized to negotiate with the IRS on your behalf. Without the expertise of such a professional, you may never be able to address your tax penalties from early withdrawal properly. US Tax Shield can help you get back on your feet and move in the right direction. Contact our team today at (877) 829-3535 for a no-obligation consultation.
