401(k) - Withdrawal of Funds

Withdrawal of Funds

Virtually all employers impose severe restrictions on withdrawals of pre-tax or Roth contributions while a person remains in service with the company and is under the age of 59½. Any withdrawal that is permitted before the age of 59½ is subject to an excise tax equal to ten percent of the amount distributed (on top of the ordinary income tax that has to be paid), including withdrawals to pay expenses due to a hardship, except to the extent the distribution does not exceed the amount allowable as a deduction under Internal Revenue Code section 213 to the employee for amounts paid during the taxable year for medical care (determined without regard to whether the employee itemizes deductions for such taxable year).

In any event any amounts are subject to normal taxation as ordinary income. Some employers may disallow one, several, or all of the previous hardship causes. Someone wishing to withdraw from such a 401(k) plan would have to resign from their employer. To maintain the tax advantage for income deferred into a 401(k), the law stipulates the restriction that unless an exception applies, money must be kept in the plan or an equivalent tax deferred plan until the employee reaches 59½ years of age. Money that is withdrawn prior to the age of 59½ typically incurs a 10% penalty tax unless a further exception applies. This penalty is on top of the "ordinary income" tax that has to be paid on such a withdrawal. The exceptions to the 10% penalty include: the employee's death, the employee's total and permanent disability, separation from service in or after the year the employee reached age 55, substantially equal periodic payments under section 72(t), a qualified domestic relations order, and for deductible medical expenses (exceeding the 7.5% floor). This does not apply to the similar 457 plan.

Many plans also allow employees to take loans from their 401(k) to be repaid with after-tax funds at pre-defined interest rates. The interest proceeds then become part of the 401(k) balance. The loan itself is not taxable income nor subject to the 10% penalty as long as it is paid back in accordance with section 72(p) of the Internal Revenue Code. This section requires, among other things, that the loan be for a term no longer than 5 years (except for the purchase of a primary residence), that a "reasonable" rate of interest be charged, and that substantially equal payments (with payments made at least every calendar quarter) be made over the life of the loan. Employers, of course, have the option to make their plan's loan provisions more restrictive. When an employee does not make payments in accordance with the plan or IRS regulations, the outstanding loan balance will be declared in "default". A defaulted loan, and possibly accrued interest on the loan balance, becomes a taxable distribution to the employee in the year of default with all the same tax penalties and implications of a withdrawal.

These loans have been described as tax-disadvantaged, on the theory that the 401(k) contains before-tax dollars, but the loan is repaid with after-tax dollars. While this is precisely correct, the analysis is fundamentally flawed with regard to the loan principal amounts. Some will argue that the loan is repaid with after-tax dollars, but the loan itself is not a taxable event, so the "income" from the loan is tax-free, but the "fact" that you get taxed a second time when you do retire and get your final distribution is a red herring. From your perspective as the borrower, this is identical to a standard loan where you are not taxed when you get the loan, but you have to pay it back with taxed dollars. However, the interest portion of the loan repayments, which are essentially additional contributions to the 401k, are made with after-tax funds but they do not increase the after-tax basis in the 401k. Therefore, upon distribution/conversion of those funds the owner will have to pay taxes on those funds a second time.