How the 401(k) Works

• Whenever you decide to take a withdrawal from your 401(k) retirement plan, the distribution you receive is added to your annual taxable earnings. These plans are favored because they assume that when you're eligible to take a distribution, usually after age 59-1/2, your income will be lower because you will no longer be employed, resulting in a lower income tax rate. If you take an early distribution from your 401(k), it will be added to your current income and taxed.
  
  

State and Federal Taxes

• In Kansas, workers who earn more than $15,000 annually pay 6 percent in state income taxes; those who earn less than $15,000 pay 4 percent. The big tax bill comes from the federal government, whose tax rate begins at 10 percent and tops out at 35 percent. In addition, you'll have to pay a 10-percent penalty on your early distribution. This means that top Kansas earners could lose as much as 51 percent of an early distribution to state and federal income taxes and penalties.
  
  

Exceptions

• The federal government recognizes that there are occasions that merit an early distribution. If your distribution qualifies, you won't have to pay the 10 percent penalty, and you also may not be taxed. For example, if you are the beneficiary of a deceased account holder, then your inheritance passes to you with no penalty or tax. If you become disabled, you won't have to pay the penalty. Court-ordered domestic settlements and medical expenses may qualify. The penalty is also waived if you leave your job and you are at least 55.
  
  

Two Alternatives

• If you have the option, consider taking a 401(k) loan instead of an early distribution. You're borrowing from yourself, and you even repay yourself with interest. The loan is tax-free and you won't need a credit check. You probably won't be able to access the entire value of your account, but it may be enough to tide you over. Alternatively, if you have an IRA and anticipate having the means to pay it back, you can take a temporary, 60-day withdrawal, tax-free. Keep in mind that this is a very risky solution -- if you can't make repayment within 60 days, you're subject to the 10-percent penalty as well as state and federal income taxes.