The IRS requires 20 percent withholding from 401(k) withdrawals.
Minimum 20 Percent
The Internal Revenue Service mandates that your financial institution withhold a minimum of 20 percent of each 401(k) plan distribution for potential income taxes due when you file your taxes. This rule applies no matter how much other income you have or what you're planning to use the money for. For example, say you are laid off on Jan. 1, have no income all year and live off savings until December, when you withdraw $10,000 from your 401(k). Even though you're not going to owe 20 percent in taxes and penalties, you still have 20 percent withheld.
Mandatory Withholding Doesn't Equal Taxes Due
Just because you have 20 percent withheld from your 401(k) distribution doesn't mean you won't owe extra when you file your return. If you don't have enough money withheld from your distribution to cover taxes and don't qualify for an exemption
from the automatic 10 percent early withdrawal penalty, you will have to pay up when you file your tax return. Exceptions include medical expenses that exceed 10 percent of your adjusted gross income, suffering a permanent disability, taking a distribution as a result of a qualified domestic relations order or leaving your job after turning 55 years old. Of course, if 20 percent is too much to withdraw based on your annual income, you'll get a tax refund of the excess amount.
Optional Higher Withholding
The 20 percent withholding is just a minimum requirement and, if necessary, you can alter it so your withholding percentage is higher. For example, say you expect to fall in the 15 percent tax bracket and know you'll owe the 10 percent penalty on your withdrawal. You can elect to have 25 percent withheld from your 401(k) withdrawal so you won't owe extra when you file your return.
Transfers for Moving to Another Retirement Plan