What’s the truth about penalties and taxes for a 401(k) withdrawal?

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Q. I recently called my 401(k) company to inquire about a withdrawal. I asked three different people and received three different answers. One person told me a withdrawal will mean a 10% flat tax and no penalty. The second person said 20% and no penalty. The third said I’d pay my regular tax rate and no penalty. I’m 42 years old. Who is right?
— Still working

A. It’s very frustrating to get so many different answers for the same question.

Here’s the correct answer.

For all 401(k) withdrawals, the withdrawal is treated as added income on your tax return, so you’ll be taxed at your ordinary income tax rate, said Nicholas Scheibner, a certified financial planner with Baron Financial Group in Fair Lawn.

Typically, if you withdraw from your 401(k) prior to reaching age 59 ½, you will be penalized 10% on the withdrawal. There are a few exceptions to the penalty, but no exception to the taxes, he said.

But this year, because of the coronavirus, there are changes to the penalty for withdrawals If you have experienced a disability or severe financial hardship, you may be able to request a penalty-free withdrawal from your 401(k), he said.

Learn more about the new rules for a 2020 coronavirus-related distribution here. 

Scheibner said when you call your administrator, make sure you understand the difference between a “withholding” and the “actual taxes paid.”

“Many 401(k)s recommend a 10% or 20% withholding, but that is only an estimated amount of what you may pay on the withdrawal,” he said. “You won’t know the true tax cost of your withdrawal until you file your tax return and add all your income for the year.”

But there is also more favorable tax treatment for a coronavirus-related distribution. You have the option to spread the tax bill over three years. 

Once you turn 55, if you no longer work for the company, you can withdraw from that company’s 401(k) without penalty, he said.

“This is an important distinction between 401(k)s and IRAs, and you should consider your financial needs before rolling over your 401(k) to an IRA before age 59 ½,” he said. “Note that you may be able to avoid the 10% penalty by taking a `series of substantially equal payments’ under the 72(t) rules, but it is not recommended for a one-time withdrawal need.”

Also, if you’re still working for the company and you need money from your 401(k), you can ask your administrator if they offer loans, Scheibner said.

“However, doing so will decrease the amount of funds subject to potential investment growth,” he said. “Also, if you lose your job, you may be required to pay back the loan quickly.”

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This story was originally published Nov. 25, 2020.

NJMoneyHelp.com presents certain general financial planning principles and advice, but should never be viewed as a substitute for obtaining advice from a personal professional advisor who understands your unique individual circumstances.