How Early 401(k) Withdrawal Contributes to Tax Debt

While a 401(k) is not an absolute guard against potential hardship, it is an ideal way for you to secure the later years of your life. Carefully following 401(k) regulations can also prevent the accumulation of tax debt and IRS penalties.

What is a 401(k) Plan?

A 401(k) is a “qualified” retirement savings and investing plan offered by employers. Typically, this money is saved for retirement and invested in a variety of mutual funds. A 401(k) is also eligible for tax benefits under IRS guidelines.

How Does a 401(k) Plan Work?

Standard 401(k) plans are set up between employers and employees and allow employees to automatically divert a portion of their salary into an investment. These earnings are invested in the employee’s choice of stocks, bonds, mutual funds, and cash.

Moreover, invested funds are not taxed until withdrawn from the 401(k). Keep in mind that you cannot withdraw any money from the account until you are 59½, or you will incur a tax penalty.

Types of 401(k)s

Not every employer will offer access to a traditionally 401(k) plan – thankfully, there are other types of 401(k)s.

Traditional 401(k) Plans

A traditional 401(k) plan involves the employee contributing earning into an investment, which is tax-deferred, or – in other words – income taxes are applied when savings are withdrawn.  

Safe Harbor 401(k) Plans

Safe harbor 401(k) plans require employers to make contributions to each employee’s 401(k) plan; also, they automatically pass the non-discrimination test.

SIMPLE 401(k) Plans

A SIMPLE 401(k) plan combines the qualities of a traditional 401(k) and a SIMPLE IRA. This type of 401(k) is ideal for companies with 100 or fewer employees, and it caps employee contributions at a lower annual amount.

Solo 401(k) Plans

Solo 401(k) plans are for employers who have no full-time employees besides their spouses and partners.

Roth 401(k) Plans

Roth 401(k) plan requires employees to pay income tax immediately on their contributions. Conversely, money taken out at retirement does not have any further taxes due.

401(k) Plan Benefits

Such benefits of utilizing a 401(k) include tax advantages, easy payroll deductions, financial safeguards, and loans.  

Tax Advantages

Contributions to your 401(k) are pre-taxed, meaning that the IRS doesn’t get a slice. Growth on your investments is not taxed. Pre-tax contributors to your 401(k) also lower your total taxable income for the year.

Easy Payroll Deductions

A traditional 401(k) plan allows eligible employees to make pre-tax deferrals through payroll deductions.

Financial Safeguards

You won’t need to worry about creditors coming after your 401(k); the Employee Retirement Income Security Act of 1974 protects it.

Loans

Sometimes, taking out a short-term 401(k) loan and paying it back on schedule is a sensible idea. However, some experts would argue against such actions.

How Do You Get a 401(k) Plan?

Employers offer 401(k) plans to their employees. Of course, as stated earlier, not every employer will offer such a benefit. When applying for a job, companies will mention if they offer a 401(k) plan. If you’re unsure if your work provides this – ask your supervisor.

Nevertheless, there are various alternatives, such as individual retirement plans like a Roth IRA. With a Roth IRA, you have to pay income tax immediately upon contributing to your account. However, unlike a 401(k), the money you take out at retirement (or whenever) does not get taxed.

How Can a 401(k) Contribute to Tax Debt

You must be at least 59½ years old or have qualified for an exception to pull money out of your 401(k). Otherwise, the cash you take out is subject to taxes, penalties, and withholdings.

The money you take out prematurely is taxed as ordinary income, the IRS will require automatic withholdings of 20% for taxes, and the IRS may assign a 10% penalty when you file your next tax return.  

Suppose you took out $10,000; you might have to give the government $1,000 of that plus the taxes we spoke of earlier, meaning you could only get about $7,000 of the original.

Often, our clients have tax debt because they made a withdrawal, spend it, then realized later that they spent more money than they technically had.

How to Avoid Getting Tax Debt From 401(k)?

Most financial experts would advise against making a withdrawal from your 401(k) because of the long-term implications such as stunting your retirement. However, if you must make a withdrawal due to an emergency or hardship, you do have some options.

Avoid Early Withdrawal Penalty

You can contact the IRS and see if you qualify for a hardship withdrawal. The IRS defines a hardship withdrawal as “an immediate and heavy financial need.”

Roll Over Your 401(k) Without Tax Withholdings

If you need to switch jobs, or if you must make a withdrawal from your 401(k), convert your 401(k) into an IRA. There is no 10% penalty when withdrawing from an IRA.

Avoid Two Distributions in the Same Year

At the age of 72, you must take the required minimum distributions (RMD) from your retirement accounts. Should you withdraw less than the RMD or make two distributions in the same year, you will owe the IRS an excise tax of 50% of the deficit.

Roth Accounts

Alternatively, you could invest in a Roth account over a traditional 401(k). You can take out money anytime from a Roth 401(k) without incurring a penalty because income tax is paid immediately upon contributing to a Roth 401(k).

Separate Tax-Preferred Investments from Your Retirement Account

Make tax-efficient investments in taxable accounts and make tax-inefficient investments in tax-deferred or tax-exempt accounts.

Tax Loss Harvesting

To minimize any taxes you may owe on capital gains or regular income, deploy tax-loss harvesting on accounts like IRAs and 401(k)s. Tax-loss harvesting involves selling an investment that has lost value and replacing it with a similar investment to offset any realized gains.  

Summary     

A 401(k) is a great investing tool primarily withdrawn at retirement. While not all employers offer it, there are various forms and alternatives, such as a Roth IRA.

One of the primary reasons why our clients have accumulated tax debt is because of early 401(k) withdrawals. If you are currently experiencing tax debt as a result of an early withdrawal, please call us at 833-419-RISE(7473), and we’ll connect you with one of our tax experts.