Can the 10% penalty for early withdrawal from 401k still be tax deductible? If I’m eligible for an EV credit of $7500 can that cover the penalty?

[seanvoight]

I am eligible for the $7,500 electrical vehicle credit but I won’t owe $7,500 in federal taxes.  I’m considering taking a withdrawal from my 401k since I’ll have extra credits available to me.  If I take $10,000 (counted as income I understand) will the $1,000 tax penalty that results be deductible or do I owe that no matter what?

[Critter · Accepted solution]

Sorry ... but the EV credit can ONLY be used against federal income taxes ... it cannot be used against the 10% penalty.

Look at the form 1040 ... the EV credit is used on line 54 and the 10% penalty is all the way down on line 59. 

[dmertz]

You can avoid the penalty by doing a rollover from the 401(k) to a Roth IRA instead.  By doing so you'll incur the taxable income without the penalty and growth in your Roth IRA will eventually be tax free instead of being only tax deferred if the money remained in your 401(k).

[seanvoight]

Ok I’ll have to look into this.  Is it possible to do a rollover from a 401k to a Roth IRA if I am still working for the employer? Or would I still take it as a withdrawal and file for the fee to be waived after proving I put the money into a Roth IRA?

[dmertz]

In most cases, no, but it's plan dependent.  The employer's plan would have to allow an in-service distribution and, since you are under age 59½, that in-service distribution is not permitted to include any portion attributable to your elective deferrals.  Even if you are not permitted an in-service distribution, if the employer plan has a Designated Roth Account you could potentially do an In-plan Roth Rollover, avoiding the issue of an in-service distribution from the plan while still incurring the tax liability, avoiding the penalty and getting the funds into a Roth account.

If you are not permitted an in-service distribution you would not even be able to take the distribution from the plan that you were originally asking about since it would have to be a hardship distribution and simply wanting to have an additional tax liability to which to apply your tax credit does not meet the definition of a hardship.  Without being able to take an in-service distribution, a rollover to a Roth IRA could not be done either directly or indirectly.  Even if you could take a hardship distribution, hardship distributions are not eligible for rollover; there would be no avoiding the 10% early-distribution penalty unless you had some exception that applied.

[seanvoight]

I see.  My plan allows withdrawals and I also checked and I can do a roll over to a Roth IRA.  When doing the withdrawal it shows me that taxes will be withheld (20% fee and 3% state) but when doing the rollover to Roth IRA it doesn’t show any tax liability.  If I do the Roth IRA Rollover there will definitely be a tax liability right?

[dmertz]

Ignoring any early-distribution penalty, a rollover to a Roth IRA is subject to ordinary income tax to the same extent that it would be subject to ordinary income tax if the distribution was paid to you instead.  Tax withholding can be avoided by doing a direct rollover to the Roth IRA (which is probably the reason you saw no tax withholding for doing the rollover).  If an in-service (not hardship distribution) is permitted, the plan is required to allow a direct rollover to a Roth IRA.  If the distribution is instead paid to you and you roll the distribution over to the Roth IRA yourself within 60 days, a minimum of 20% withholding is required by federal law (and there might be mandatory state withholding as well, depends on the state), so you would have to use other funds to complete the rollover to the Roth IRA of the portion withheld for taxes, then get the tax withholding back as part of your tax refund.

The assumption here is that you are asking in regard to 2018 since it's to late to treat any distribution from the 401(k) as income for 2017.

[seanvoight]

Ok I think I understand.  It is an in service direct rollover that Fidelity allows.  So they are not withholding any money so they full amount rolls over but a tax liability will still be realized at the end of the year right?  I think this will work out perfectly for what I need to accomplish.  I’ll just need to calculate my expected wages and tax liability and do a Roth conversion for the rest.  Thanks!

[dmertz]

Whether or not an in-service rollover is allowed is governed by the 401(k) plan agreement, not the trustee, although the trustee should be enforcing the distribution limitations dictated by the plan.