Tax on Early 401(k) Distrbutions

People may consider taking early distributions from 401(k) accounts when facing financial difficulty, but those distributions can be costly. In addition to regular income tax on retirement distributions, federal law imposes a 10% penalty on distributions received from 401(k) plans before age 59 1/2, unless a distribution is:

• made on or after the account holder's death,
• made on account of disability,
• made for certain unreimbursed medical expenses (which must be incurred in the same year the distribution is received)
• due to an IRS levy,
• made as part of a series of substantially equal periodic payments over life expectancy,
• a qualified reservist distribution,
• made after separation from service after age 55,
• made to an alternate payee under a qualified domestic relations order, or
• made from an employee stock ownership plan for dividends on employer securities held by the plan.

California imposes another 2.5% tax on early 401(k) distributions not meeting one of these exceptions. So, unless an exception applies, Californians pay 12.5% in penalties on early 401(k) distributions in addition to income tax.

A plan loan may be a better alternative to a distribution. If your plan provides for loans and certain conditions are met, you could receive the funds tax-free.

Answers to 401(k) FAQs are available at http://www.irs.gov/faqs/content/0,,id=199909,00.html.