Understanding Qualified Distributions
Early 401(k) Withdrawal Rules
Borrowing from 401(k)
Early IRA Withdrawal Rules
Roth 401(k) and Roth IRA Withdrawal Rules
Minimum Required Distributions
Frequently Asked Questions (FAQs)
What Are Qualified Distributions?
Qualified distributions are those that can be taken without paying taxes or penalties. They are taken after the age of 59 and a half or in certain other allowable situations.
There is no penalty for withdrawing your funds after reaching age 59 and a half, but you will pay income tax on the amount you withdraw if you invested in a pre-tax 401(k) plan or traditional IRA with non-deducted funds. You deducted tax at the time you made the contributions.
Investments in Roth IRAs and Roth 401(k)s are made with after-tax dollars. These distributions are not subject to tax when you withdraw them, but you must have owned the Roth account for at least five years.
Note: It is generally better to start withdrawing funds from tax-deferred accounts – those from which you deducted taxes – after retirement. You may be in a lower tax bracket at that time since you will no longer be earning wage income.
Early 401(k) Withdrawal Rules
Early withdrawals are those taken from a 401(k) before reaching age 59 and a half. They are taxed as ordinary income. Additionally, they are subject to a 10% additional penalty, but there are some exceptions to this rule. You can take funds without penalty if you are completely and permanently disabled, if you lost your job when you were at least age 55, or under the terms of a qualified domestic relations order (QDRO).
You can also use 401(k) funds to pay for medical expenses that exceed 7.5% of your adjusted gross income (MAGI), as long as your insurance company does not cover them. In other words, you paid out of pocket.
Note: You will not only lose a significant portion of your savings due to taxes when you make an early withdrawal, but you will also miss out on the growth that would have occurred on the withdrawn amount.
Some 401(k) plans allow for hardship withdrawals, but these often must be approved by your employer. They must be for the purpose of meeting an immediate and important need. The amount should not exceed what is needed to meet that need.
Borrowing from 401(k)
A 401(k) loan can be a better option than an early withdrawal if your employer allows it. There is no credit check with this type of loan. Interest rates are also lower than other loans, but fees may apply. You must repay the amount to yourself with interest, and you must do so within five years – or almost immediately if you leave your job.
You will lose one of the main benefits of a 401(k) if you take a loan, because you must repay the amount with after-tax dollars. You will also miss out on what could be critical months or years of earnings on that money.
Another major downside is that you may have to repay the loan within 90 days if you leave your job for any reason. Your loan balance will be treated as taxable income in that year if you do not. This may push you into a higher tax bracket, and you may also incur the 10% early withdrawal penalty.
Early IRA Withdrawal Rules
Early withdrawals from traditional IRAs are also subject to income tax and a 10% penalty. They have many of the same exceptions to the penalty as 401(k)s, but there are some differences.
You can withdraw early if you use the money to pay for certain qualified higher education expenses, health insurance costs that you must pay while unemployed, or to buy a first home.
Note:
IRAs do not require a Qualified Domestic Relations Order (QDRO) to divide the account after divorce, but they are still subject to some rules.
Roth 401(k) and Roth IRA Withdrawal Rules
Roth accounts are funded with after-tax dollars, so withdrawals from them are not treated the same way as withdrawals from regular IRAs and 401(k)s. Distributions are tax-free, provided you are at least 59 and a half years old and have owned the Roth account for at least five years. The age rule does not apply if the account owner is disabled or deceased.
There is still a 10% penalty tax for early withdrawals, but this only applies to earnings. You can withdraw your original contribution amount tax-free before age 59 and a half because you have already paid tax on that money.
Required Minimum Distributions
You must begin taking Required Minimum Distributions (RMDs) from your traditional IRA account when you turn 72. The Internal Revenue Service (IRS) will penalize you 50% of the amount you should have taken if you do not.
Note: The minimum year to start RMDs was 70 and a half before the passage of the SECURE Act in 2019. Now the age is 72 for anyone born after June 30, 1949.
The IRS uses life expectancy tables to determine how much you should take each year to avoid this 50% penalty. However, your 401(k) account can remain intact as long as you are still working, and Roth IRA account holders are not required to take RMDs at any time.
Frequently Asked Questions (FAQs)
How to report a 401(k) withdrawal on a tax return?
Your plan provider will send you Form 1099-R, which will include the details you need to report on your tax return. If your withdrawal is an early withdrawal, you may need to complete Form 5329, which helps you calculate the tax on early distributions. If you only owe an additional 10% tax on the full amount of the early withdrawal, you may be able to report it directly on Schedule 2 of your Form 1040.
What qualifies for a hardship withdrawal from a 401(k)?
If your 401(k) plan allows for hardship withdrawals, they can only be made if the distribution arises from an immediate and heavy financial need. The distribution is also limited to the amount necessary to meet that need. Immediate financial needs include medical expenses, costs for purchasing a home, tuition and fees for higher education, payments to prevent eviction or foreclosure, funeral expenses, and certain home repair costs. You may need to document the expense to show the plan that it has only distributed the necessary amount to cover the need.
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Source: https://www.thebalancemoney.com/how-to-withdraw-money-from-a-401-k-or-ira-2894212
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