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?

401(k), Income Tax
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December 2016

Hello,

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. 

Yours,

Russ

December 2016