401K Clarification

In my article–Live Poor or Die–i confused two basic points on taking money from your 401K.The Pension Rights Center has kindly clarified the situation as follows:  

A participant who takes a loan from his own 401(k) does not immediately pay a 10% tax, but if the participant just takes his money out of the 401(k) without a loan, a hardship withdrawal, or rollover into another tax favored account, then he would be subject to the 10 percent excise tax.  In a loan situation, if the participant is unable to repay the loan, the outstanding loan amount at that time becomes taxable in the current tax year.  As a penalty for taking the money prior to retirement age, a participant would owe 10 percent of the outstanding loan amount to the IRS as an excise tax.  The outstanding balance would also be reportable as income in the current year on the participant’s tax return.

This can especially be a problem for people who lose their jobs while they have an outstanding loan from a 401(k).  Upon leaving employment, a balance of a loan from a 401(k) is immediately due in full.  Often people who just lost their jobs are not in a position to repay the loan.  When that happens there is a 10 percent excise tax and the employee has to report the additional income in the current tax year.


One response to “401K Clarification

  1. I would note that it may be a little more complicated. A 2009 GAO study shows most leakage occurs due to loans, but from distributions after separation. Some surveys suggest 50% take distributions after separation – particularly where the account balance is relatively small.

    At the same time, the distribution may actually be subject to less taxes. That is, if timed so that it is the only taxable income in the calendar year, the 10% penalty tax may be a lower marginal rate than what would have otherwise been paid.

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