1. When can I take money out of my 401(k) account?
2. What is the penalty if I take money out of my 401(k) before I'm 59ý?
3. How is the 10 percent penalty tax calculated?
4. What if I need money in an emergency?
5. Under what circumstances can an individual begin to receive distributions from a 401(k) or qualified savings plan before age 59ý?
6. What happens if I inherit someone else's 401(k) account?
7. When am I required to start withdrawing money from my 401(k) account? When do I have to close it?

1. When can I take money out of my 401(k) account?

You should check with your company's human resources or benefits representative regarding the rules for your specific plan. Below is general information about some situations in which distributions are permitted, and the related penalties and tax implications for each.

Once you reach age 59ý you can generally begin to withdraw money from your 401(k) with no penalty. Federal, state and local income taxes are due on the amount you withdraw.

There are two situations where you may take money out of the plan prior to retirement, providing your plan allows this. One is to make a withdrawal to cover a financial hardship. The other is to take a withdrawal allowed under Section 72(t) of the IRS Code.

Hardship withdrawals are subject to a 10 percent early withdrawal penalty while Section 72(t) withdrawals aren't. Both types of withdrawals are subject to applicable federal, state and local income taxes.

You may qualify for a hardship withdrawal if you need the money for any of the following reasons:

• to pay college tuition for yourself or a dependent, provided it's due within the next 12 months;
• to purchase a primary residence;
• to pay unreimbursed medical expenses for you or your dependents; or
• to prevent foreclosure or eviction from your home.

By the way, your employer may require you to provide financial records to prove the need for a hardship withdrawal.

Under the following circumstances the IRS says you may withdraw money before age 59ý without owing the 10 percent penalty:

• If you become totally disabled.
• If you die, and your beneficiary collects the money.
• If you are in debt for medical expenses that exceed 7.5 percent of your adjusted gross income.
• If you are required by court order to give the money to your divorced spouse, a child, or a dependent.
• If you are separated from service (through permanent layoff, termination, quitting or taking early retirement) in the year you turn 55, or later.
• If you are separated from service and you have set up a payment schedule to withdraw money in substantially equal amounts over the course of your life expectancy. (Once you begin taking this kind of distribution you are required to continue for five years or until you reach age 59ý, whichever is longer.)
• If the money is a dividend distribution from an Employee Stock Ownership Plan.

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2. What is the penalty if I take money out of my 401(k) before I'm 59ý?

The penalty is 10 percent of the untaxed money (contributions and earnings) you withdraw, plus applicable federal, state and local taxes on that amount. So if you were to withdraw $5,000 from your 401(k) before age 59ý, you would owe a penalty of $500 (plus applicable federal, state and local taxes on the entire $5,000).

Providing your plan allows pre-retirement withdrawals, under the following circumstances the IRS says you may withdraw money before age 59ý without owing the 10 percent penalty:

• If you become totally disabled.
• If you die, and your beneficiary collects the money.
• If you are in debt for medical expenses that exceed 7.5 percent of your adjusted gross income.
• If you are required by court order to give the money to your divorced spouse, a child, or a dependent.
• If you are separated from service (through permanent layoff, termination, quitting or taking early retirement) in the year you turn 55, or later.
• If you are separated from service and you have set up a payment schedule to withdraw money in substantially equal amounts over the course of your life expectancy. (Once you begin taking this kind of distribution you are required to continue for five years or until you reach age 59ý, whichever is longer.)
• If the money is a dividend distribution from an Employee Stock Ownership Plan.

Any money withdrawn for the above reasons would still be subject to applicable federal, state and local income taxes.

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3. How is the 10 percent penalty tax calculated?

The 10 percent penalty applies to the entire untaxed amount that you withdraw. The early withdrawal penalty for a $5,000 withdrawal would be $500. You would also owe applicable federal, state and local taxes on the entire $5,000.

If you've made after-tax contributions to your 401(k), it gets a bit more complicated. You do not have to pay the 10 percent penalty or any additional taxes on the amount of your after-tax contributions. You do, however, have to pay the 10 percent penalty and all taxes due on any interest earned and employer-matching contributions made as a result of your after-tax contributions.

If you're thinking "I'll just take out my after-tax contributions and leave the earnings where they are" -- nice try, but no dice. For every after-tax contribution dollar you withdraw, the IRS requires you to withdraw a proportional amount of the earnings, too.

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4. What if I need money in an emergency?

Your 401(k) plan is intended to be a long-term investment plan, but many companies allow employees to access their money during their working years through plan loans or "hardship withdrawals." However, you may still have to pay the 10 percent early withdrawal penalty on a hardship withdrawal.

The IRS defines "financial hardship" as the need to withdraw money A) to pay college tuition for yourself or a dependent, provided it's due within the next 12 months; B) to make a down payment on a primary residence; C) to pay unreimbursed medical expenses for you or your dependents; or D) to prevent foreclosure or eviction from your home. While distributions are generally allowed for those reasons, you may still have to pay the 10 percent premature distribution penalty unless you can prove you are in truly dire straits. All applicable federal, state and local income taxes are also due on the amount you withdraw.

With plan loans, however, there are no taxes or penalties owed. Although legally, loans can be allowed for any reason, many plans permit them only in specific, approved situations such as paying college tuition or buying a house. Repayments of loan principal and interest are deducted directly from your paycheck and deposited in your 401(k) account. If, however, you leave your job before paying back your loan, it may be considered to be in default, and if you fail to repay it within any grace period granted by your former employer, you will owe taxes and penalties on the outstanding balance.

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5. Under what circumstances can an individual begin to receive distributions from a 401(k) or qualified savings plan before age 59ý?

You should check with your company's human resources or benefits representative regarding the rules for your specific plan. Below are some general situations where distributions are permitted, and the related penalties and tax implications for each.

There are two situations where you may be able to take money out of the plan prior to retirement. One is to make a withdrawal to cover a financial hardship. The other is to take a withdrawal allowed under Section 72(t) of the IRS Code.

Hardship withdrawals are subject to a 10 percent early withdrawal penalty while Section 72(t) withdrawals aren't. Both types of withdrawals are subject to applicable federal, state and local income taxes.

You may qualify for a hardship withdrawal if you need the money for any of the following reasons:

• to pay college tuition for yourself or a dependent, provided it's due within the next 12 months;
• to purchase a primary residence;
• to pay unreimbursed medical expenses for you or your dependents; or
• to prevent foreclosure or eviction from your home.

By the way, your employer may require you to provide financial records to prove the need for a hardship withdrawal.

Under the following circumstances the IRS says you may withdraw money before age 59ý and not have to pay the 10 percent penalty:

• If you become totally disabled.
• If you die, and your beneficiary collects the money.
• If you are in debt for medical expenses that exceed 7.5 percent of your adjusted gross income.
• If you are required by court order to give the money to your divorced spouse, a child, or a dependent.
• If you are separated from service (through permanent layoff, termination, quitting or taking early retirement) in the year you turn 55, or later.
• If you are separated from service and you have set up a payment schedule to withdraw money in substantially equal amounts over the course of your life expectancy. (Once you begin taking this kind of distribution you are required to continue for five years or until you reach age 59ý, whichever is longer.)
• If the money is a dividend distribution from an Employee Stock Ownership Plan.

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6. What happens if I inherit someone else's 401(k) account?

A distribution of a 401(k) account to a beneficiary is considered income, and the recipient must pay income tax on it. In addition, the total account is included in the estate of the deceased and is therefore also subject to estate tax. The combination of income and estate taxes can easily take 70 percent or more of the account.

Under most circumstances, a spouse may be permitted to roll the money over to an IRA, but a professional tax advisor should be consulted on this point. There are legal requirements that generally force a non-spouse beneficiary to take the money out of the 401(k). A non-spouse beneficiary is not allowed to roll over an inherited 401(k) to his or her own 401(k) or an IRA. The rationale for these restrictions is that 401(k) tax breaks are designed to help workers build funds for retirement, not to build an estate that will pass to heirs without tax.

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7. When am I required to start withdrawing money from my 401(k) account? When do I have to close it?

You must begin taking distributions from your 401(k) plan by April 1 of the calendar year following the calendar year in which you turn 70ý. Otherwise you will be liable for a penalty of up to 50 percent of what you should have taken out, but didn't. An exception is made if, at age 70ý, you are still working for the employer who sponsors your 401(k) plan. In that case you are required to start taking distributions by April 1 of the calendar year following the year in which you retire.

Once you retire, you have the option of leaving your account with your former employer, providing there is $5,000 or more in it. There is no requirement for you to close the account as long as your former employer continues to sponsor it.

If your balance, however, is less than $5,000 and more than $1,000, your employer may decide to automatically roll it into an IRA account on your behalf. You would then take distributions from the IRA according to the IRS' required distribution rules. If your money is automatically rolled over in this instance, there are no tax consequences because the money is moving from one tax-deferred account to another.

If for some reason your former employer were to stop sponsoring the 401(k) plan, you could either take a lump sum distribution or roll the account over into a rollover IRA. If you took a lump sum distribution you would have to pay tax on the entire amount, but if you qualify, you might be able to spread the tax over 10 years. If you rolled the money over into an IRA you would not have to pay taxes until you withdrew the money and you will have to begin taking distributions according to the IRS' required distribution rules.

It would be a good idea to contact the appropriate tax/estate planning and investment professionals for advice in this situation.

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