Can I Spend My 401(k) Now and Report It As Income Next Year?

No. Read on to understand why this doesn’t work

Reviewed by Ebony HowardReviewed by Ebony Howard

Any amount withdrawn from your 401(k) account must be treated as ordinary income for the year in which the money is taken out. Withdrawals before the age of 59½ are considered early withdrawals. Some provisions do not incur the 10% penalty if withdrawn from your 401(k) account before this age. Read on to learn the rules that govern how to report funds taken out from your 401(k) retirement account.

Key Takeaways

• Early withdrawals from an IRA—meaning money withdrawn before the participant turns 59½, are subject to a 10% early withdrawal and a tax payment due in the filing year.
• There are some exceptions to the 10% rule, such as for first-time homebuyers and for people with medical emergencies.
• Money borrowed from an IRA normally needs to be returned within 60 days.

Exceptions to the Rules

There are exceptions to the rules on early withdrawals from retirement plans. The IRS allows them in certain very specific cases. This is not a break on the income tax owed. It’s a break on the penalty.

For example, first-time homebuyers and people who have huge unreimbursed medical expenses may be eligible, depending on the type of retirement plan they participate in.

You may also be eligible to take a loan from your own account, in certain cases.

Important

Any money you take from a 401(k) plan must be reported as ordinary income in the same year that you made the withdrawal.

Tax and Penalty Liability

If you have no option but to withdraw money from your retirement account, you can still roll over the amount to an IRA within 60 days of receiving the check without incurring taxes and penalties. This is known as an indirect rollover.

When you take the withdrawal, the plan administrator must withhold 20% for federal taxes. State tax withholding may also apply.

If you can’t make that rollover happen within the 60-day limit and you are younger than 59½, you must pay all the income taxes due plus a 10% early withdrawal fee.

If you can’t roll over the money within 60 days but want to avoid the mandatory tax withholding, you should have the amount processed to a traditional IRA as a direct rollover. This means the money will go directly from one plan to another without passing through your hands.

Then you can take the distribution from the IRA, which allows you to waive withholding. You will have to pay the taxes when you file, though.

The Last Resort

Withdrawing from your retirement plan should be a last resort, as you not only lose part of your nest egg but also damage its power to accrue earnings on a tax-deferred basis. The impact can be quite significant and could put you behind with your retirement program.

If you haven’t left your job, you may be able to take a loan from your 401(k) instead of withdrawing the money. That can be a better option, but an option that has its own possible drawbacks.

Another Option

If you have left your job, you may be eligible for unemployment insurance in your state. See the U.S. Department of Labor website for details. This could provide sufficient income until you find another job and negate the need to tap into your 401(k) plan.

You may want to talk to a retirement or financial counselor for some additional financial guidance.

Advisor Insight

Steve Stanganelli, CFP®, CRPC®, AEP®, CCFS
Clear View Wealth Advisors, LLC, Amesbury, Mass.

You may access your 401(k) to fund your living expenses. However, [if you are no longer working for that employer] it must be a withdrawal. You will not be able to take out a loan, as you could have when you were an employee, but will instead have to pay what you take back by the due date of your federal income tax return that year.

How much this will cost you depends on your age. If you’re 59½ or older, you won’t have to deal with the 10% early withdrawal penalty. If you’re under 59½, you’ll have to pay the penalty, unless you use the funds for medical expenses that total more than 10% of your gross income. Then you’ll likely be eligible for an exemption. You can also avoid the penalty via the 72(t) rule: receiving “substantially equal periodic payments” over the next five years.

In all cases, your distributions will be counted as income in the year of withdrawal, and you’ll owe tax on them. It may help to have the 401(k) custodian withhold a percentage for taxes with each distribution.

Does a 401(k) Affect Your Tax Return?

No, contributions to your 401(k) won’t affect your tax return. Contributions are taken out of your paycheck before taxes are calculated so there is no additional work needed on your taxes and no impact.

Does a 401(k) Withdrawal Affect Social Security Benefits?

No, 401(k) withdrawals do not affect Social Security benefits. Your withdrawal will not impact your ability to receive Social Security benefits or how much. Your withdrawals, however, will affect your adjusted gross income (AGI) which will impact how much of your Social Security will be taxed.

How Much Are 401(k) Withdrawals Taxed?

Your 401(k) withdrawals are taxed as ordinary income. So, depending on your income and the corresponding tax bracket when you make withdrawals, that will be the amount you are taxed.

The Bottom Line

401(k) withdrawals are taxed as ordinary income in the year they are taken. Early withdrawals, which are those taken before the age of 59½, incur a 10% penalty. There are exceptions to these rules, including withdrawals for first-time homebuyers and medical emergencies.

Read the original article on Investopedia.