Dear Dr. Don,
I was laid off from my job April 2009. In June, I started to borrow money from my 401(k) to make my mortgage payments -- about $2,500 to date. Will I get taxed heavily? My financial company is withholding 10 percent for taxes, but I'm still concerned. I'm afraid that when taxes are due I will get hit hard.
-- Terry Tribulation
It's pretty unusual for a former employer to allow you to borrow money from your 401(k). What would be more typical would be for any outstanding loans at the time you are laid off to become immediately due. If you failed to repay the loans, they would be considered distributions and subject to income taxes and potentially subject to a 10 percent penalty tax as well.
Proceeds from a loan from your 401(k) aren't subject to taxation because you're expected to pay back the loan. It's when the loan isn't repaid and is considered a distribution that you have to consider the tax ramifications of the distribution, including the 10 percent penalty tax.
So, your first step is to figure out if you're taking distributions or a loan from your previous employer's 401(k). The withholding of 10 percent for taxes would indicate that it's a distribution, but even this is a little curious since it would be more common for a distribution to be subject to 20 percent mandatory withholding.
If you're taking distributions to make your mortgage payments, and you're subject to the 10 percent penalty tax, you should expect to pay that penalty plus your marginal federal income tax rate, along with any state or local income taxes on the distribution. Bankrate has a table showing 2009 tax bracket rates, which can help you calculate your marginal tax rate.
Talk to your plan provider about your transactions. They'll be able to tell you whether you're taking out a loan or getting a distribution from your 401(k). If you qualify for a hardship distribution, you will still be subject to the 10 percent penalty tax. The Internal Revenue Service publication "Retirement Plans FAQs regarding Hardship Distributions" gives an overview of some issues.
To ask a question of Dr. Don, go to the "Ask the Experts" page, and select one of these topics: "Financing a home," "Saving & investing" or "Money." Read more Dr. Don columns for additional personal finance advice.
Create a news alert for "taxes"