When do we have to pay the tax for 401K withdrawals?

Question

I am planning to withdraw money from my 401K to use it for down payment on a house. The question is, when do I have to pay the tax? If I withdraw it in 2020 after I file my tax return, would I pay the tax to the IRS and state in 2021? Or would I have to pay for it right at the time I submit the withdrawal?

I am planning to withdraw from 401K, not borrow from it. So I am not planning on returning this money.

PS: I am not asking if I should withdraw from 401K to use as down payment on a house. That could be a separate topic. The question is specifically regarding the tax implications on a 401K withdrawal.

Answer 1

Will this be your primary residence? If the answer is "no", then you do not qualify. Does your employer allow "hardship withdrawals"? Not all of them do.

There will be withholding and it is not clear if that will be at 20%, 30% (if under age 59.5), or some other amount dictated by the plan. So you will pay some of it right away. Then you will settle any further taxes due by Apr 15th of the next year.

Assuming you are in the 22% tax bracket, most people find it a poor idea to borrow money at 32% interest. However, that is exactly what you will end up paying to take money out of a 401K.

Answer 2

If you withdraw the money in 2020, then by the time you file your 2020 tax return (March or April 2021 for most of us), you have to be square with the government.

Square here would be that the difference between the total tax as calculated on your form and the total money you have given to the government has to be 0. The total money you have given to the government is the sum of money withheld by various entities (i.e. your employer) and any additional payments you have made, usually known as estimated tax payments.

I chose the phrasing above, because almost surely, when you attempt to withdraw money from your 401(k) plan, the entity that administers that plan will withhold a good portion of it for these various taxes and penalties. You will probably need to tell them your tax rate, plus they will withhold the % appropriate to the penalties for early withdraw.

If your plan administrator does not do that withholding for you, then because the US tax system is a pay-as-you-go system, you will be expected to make an estimated tax payment and pay in the aforementioned income taxes and early withdraw penalties in the quarter you took the money out. If you do not make that payment, the government may assess you a penalty for not paying-as-you-go on top of all the other taxes and penalties. There is a chance you may qualify for a safe-harbor waiver of those non-pay-as-you-go penalties, but it gets complicated pretty quick. Almost surely better to make this payment yourself if your plan administrator does not take it out for you.

Answer 3

First, are you past the age at which you can make withdrawals without penalties? If not, you have to deal with that - something I know nothing about.

If you are over that age, it will (I think) depend on how the plan administrator has set things up. In the case of Vanguard, which I think is typical (and perhaps an IRS requirement), you have an option to select a percentage to be withheld when you make the withdrawal. This can be 0%, 10%, 20%, 30%, and perhaps more. Whatever you select will be withheld, and you will get a Form 1099-R at the start of the next year.

You also have to be aware of the rules for estimated tax, so that you don't wind up with an underpayment at the end of the year, which could result in penalties.