How will an early withdrawal from my 401(k) affect my income taxes?
I may choose to liquidate my 401(k), when changing jobs. After I am taxed the 20%, and an additional 10% for the early withdrawal, will that cover me on income tax for that tax year? Or will I still be taxed again on the final amount, when I file that income tax the following tax season?
To fully answer this question there are some details to consider such as:
- The amount you plan to withdraw
- The amount of your income without the withdraw
- Your current tax rate- this would be your taxable income after your deductions, if any.
The 20% you mention is withholding. Yes, it is tax, but you could owe more, and maybe less, once all is done. Consider it the same as withholding on your wages. At the end of the year, you either receive a refund (money you overpaid the government) or you may need to pay if you did not withhold enough. This additional you may pay for under withholding isn't being "taxed again." Basically, it is the amount you owe that had not been withheld during the year.
Because we don't know your exact details, let us look at a couple examples to help you determine how this will affect your decision. Of course, your best best bet would be to see a tax professional for more detailed guidance in your particular situation. This information is merely for educational purposes and are only estimates.
Example 1: This is very optimistic- You are married, you and your spouse jointly earn $55K. After an assumed $25K in deductions, let's assume your taxable income would be $30K. Let us assume you estimated your withholding accurately and you withheld $3,567.50, which is what your tax would be (based on 2017 tax tables you would be in the 15% marginal tax bracket). Without the 401(k) withdrawal, you would owe exactly what was withheld, so you and Uncle Sam are square. However, let us assume you pulled out $30K from your 401(k). 20% is sent to the government for taxes ($6,000) and 10% for penalty ($3,000). You receive a check for $21K. At tax time, your withholding is now $3,567.50 + $6,000 = $9,567.50. Your taxes would now be based on $60K: $55K + $30K - $25K = $60,000. Because you are married, you are still in the 15% tax bracket, so your tax would be $8,067.50. You had $9,567.50 withheld, so you could get a $1,500 refund.
Example 2: This is more realistic- Assume you are single. All the income and deduction numbers are the same. In this case, you would owe $4,033.75 in taxes. Again, let us assume you estimated this correctly so you are even at the end of the year. Now, let us assume you again pull out $30K from your 401(k). Let's assume your taxable income (because your deductions are the same) is still $60K. Because you are single, this puts you in the 25% tax bracket. Your taxes would then be $10,738.75. Your withholding of $4,033.75 from wages plus the $6,000 from the $401(k) is $10,033.75. In this example, you could potentially need to send a check to the IRS for $705. You aren't being "taxed again." Your withdrawal put the last $22,050 of your taxable income into the 25% tax bracket (for single tax payers, income between $37,950 to $91,900 is in the 25% tax bracket).
Based on your state, you could be liable for state taxes and state penalties as well. This is why it is important to see a professional to help you with your particular situation. Also, these were simple examples. If you have other income, tax credits, etc., the answer could be much different.
While you may choose to liquidate your 401(k) upon changing jobs, the bigger question to ask is: Why?
Funds set aside from your paycheck in an employer-sponsored plan like a 401(k) are for funding your future retirement lifestyle. Taking the funds out upon changing jobs opens you up to current year taxation and defeats the original purpose of these types of accounts.
So there's more to this than the hard 'cost' of the taxes owed. You're also losing out on the ability for funds to grow tax-deferred which means you're losing out on the power of your money to grow compounded without being reduced by taxes.
Let's assume you have $20,000 to invest. You put $10,000 into a taxable account that earns 6% per year, and use a portion of these assets to pay taxes attributable to the account’s earnings. You put the other $10,000 into a tax-deferred account such as a 401(k) that also earns 6% per year. Assuming that you’re in the 28% tax bracket, in 30 years your taxable account will be worth about $35,500, while your tax-deferred account will be worth over $57,000. That’s a difference of over $21,000.
Even if the funds invested in the tax-deferred account are subject to federal income tax upon withdrawal--as they would be if you made pretax contributions to a 401(k)--you would come out ahead. This is true even if you took the entire amount in the tax-deferred account as a lump-sum distribution after 30 years and paid tax on the full amount (at 28% tax, you’d end up with a little over $41,000). Of course, most individuals draw on their retirement savings gradually during their retirement years--when they may be in a lower tax bracket--rather than taking a large lump-sum distribution. And this allows the remaining funds to continue to grow which may offset future inflation and taxes as well.
So when you change jobs, the more prudent action would be to roll the account to your new employer's 401(k) or your own Individual Retirement Account (IRA). In the latter, you may have more choices and be able to access lower cost funds like index mutual or Exchange Traded Funds.
But let's say you do choose to liquidate your 401(k) upon retirement. Even if you do have federal taxes taken out of 20% and an additional 10% for the early withdrawal penalty, you may still owe additional tax in the year of the distribution.
Why? Well, first off, you didn't account for state income taxes on the distribution in your question. And for both federal and state income taxes you'll need to account for how this distribution will affect your total taxable income.
All of this will depend on your filing status (i.e. single, married, head of household) and what your total taxable income is after exemptions for you, a spouse and any dependents as well as deductions (either standard or itemized).
Since your 401(k) contributions were set aside from your paycheck before any taxes, you'll have to add the distribution (the total amount not just the portion net of your 20% and 10% tax withholdings) to your income. And this could conceivably put you over any number of thresholds for taxes. For instance, if your income from all sources (W2, interest and this distribution) total more than $200,000 and you're single or head of household, then your total income will be subject to the 3.8% Medicare Surtax (or Net Investment Income Tax). If you're married filing jointly or a qualifying widow or widower, then this limit is $250,000 before this tax affects you.
So while you can 'take the money and run' after leaving your job, you really ought to go through a tax projection that takes into account all your income and estimated taxes before pulling the trigger. Seek the help of a qualified tax planner. Happy to help.