All 401(k) plan withdrawals are considered income and subject to income tax, including capital gains. When you take a premature distribution – a withdrawal before age 59½ from a 401(k), IRA or any other tax-deferred retirement account or annuity – that withdrawal is also subject to an extra 10% penalty tax from the Internal Revenue Service (IRS).
When a 401(k) Loan Becomes a Taxable 401(k) Withdrawal
Some 401(k) plans let you take out loans from up to 50% of your available account balance. If you cannot pay back the full balance of the loan within five years, then it is considered to be a withdrawal and is subject to income tax. If you are under age 59½ at that time, then that early distribution is also subject to the 10% penalty fee.
Another instance in which a 401(k) loan becomes a taxable 401(k) withdrawal is if you cannot pay back the remaining balance of the loan upon termination of employment.
Exceptions to the Extra 10% Penalty Tax
While all 401(k) distributions are subject to income tax, there are several exceptions to the extra 10% penalty tax. One is if you roll over the funds into another qualified retirement plan (see Are 401(k) rollovers taxable?).
Another concerns health-related costs. If the amount of your unreimbursed medical expenses is more than 10% of your adjusted gross income (AGI) (7.5% if you are 65 or older) and you take a distribution from your 401(k) to cover those expenses, then the IRS exempts you.
When you take a loan from your 401(k), you might open a separate checking account to deposit the withdrawal and make the medical payments. By keeping a detailed paper trail of the use of your 401(k) funds, you can be ready in case of an audit.