401(k) distribution tax calculation

Question

Wanting to receive $25k distribution from my fully vested 401k w/former employer. Figuring required 20% withdrawal penalty to be $5k (25,000 x20%), so my account balance would be reduced by a total of $30k. However, they are telling me it will be a $31,250 deduction (25,000 / .80). Is this right? Im paying tax on the tax penalty? Plus then I'll owe the IRS another 10% penalty at time of filing on which figure, $25k or $31,250?

Answer 1

I'm paying tax on the tax penalty?

No, you're paying tax on the amount withdrawn to cover the tax. If you withdraw $31,250, you'll pay a tax of $31,250 * 20% = $6,250, netting $25,000. This process is typically called "grossing up".

You could withdraw $30,000 and pay the other $1,000 of the $6,000 tax (plus the $3,000 penalty) out of pocket.

Plus then I'll owe the IRS another 10% penalty at time of filing on which figure, $25k or $31,250?

You'll owe a 10% penalty on whatever is withdrawn, so if you can't cover any tax out of pocket, you'll have to withdraw a total of 25,000 / (1 - 0.2 - 0.1) = 35,714. You'll pay a 20% tax of 7,143 and a 10% penalty of 3,571 for total tax/penalty of 10,714, netting you $25,000.

So you're effectively paying 43% in tax and penalty. Still want to make that distribution?

Answer 2

If this acct has a balance you are not disclosing, and you requested $25K in a way that specified 'net', then yes, a $31,250 distribution with $7500 withholding, will net you $25,000.

You then still owe $3,125 penalty if under 59-1/2, and still reconcile taxes at year end.

Is the need to withdraw urgent? Best to avoid it, if not.

In response to Ben's comment to D Stanley's answer, I'd like to add an important point/clarification.

A retired couple (with zero other income/no social security payments, etc, but over 55, so no penalty on 401(k) withdrawal), withdraws $100K. $20K is withheld.

$76K is taxable after standard deduction. Tax due is $8739. The mandatory 20% withholding is far more than would be needed to cover the tax for most taxpayers. Note: The top 10% of all earners is $120K or so. For the OP of this question it implies he needs to do the math to understand the actual tax due vs the 20% withheld. For others, it means a strategy of regularly transferring funds from one's 401(k) to an IRA to be able to fine tune the percent withheld.