A 401k plan is a benefit that your employer may sponsor to help you save and invest for your retirement. To receive these tax benefits, you must generally keep your funds invested until you reach retirement age. If you live in California and take out an early 401k distribution, you may owe taxes and penalties to both the IRS and the state of California.
Whether you take an early distribution or an approved distribution from your California 401k, the IRS will most likely render that income taxable. Except in unusual circumstances, the money you contribute to your 401k comes out of your paycheck before it is taxed. As a result, when that money comes out of your 401k, the IRS will tax it as if you were receiving the money for the first time, which you essentially are. Additionally, as you pay no tax on the gains in your 401k while they remain in the account, those earnings are also taxable upon distribution, regardless of when you take them out.
The IRS defines an early withdrawal from a California 401k plan to be one that you take before you turn 59 1/2 years old. Federal tax law imposes an additional 10 percent tax on most distributions taken before age 59 1/2, in order to discourage the use of 401k funds for any purposes other than retirement savings. Certain exceptions exist to this penalty. For example, if you become disabled, need money for excessive medical expenses, or use the distribution to satisfy a levy of the 401k plan, you can avoid the federal penalty tax.
California tends to follow the lead of the federal government when it comes to the taxation of 401k withdrawals. Whether your 401k distribution is early or regular, the state of California will tax your withdrawal at your state income tax level. Since you must include the amount of your 401k withdrawal in your federal gross income, you generally do not have to make any special notification to the state of California regarding your withdrawal, as the state income tax form uses the federal adjusted gross income figure as a starting point for computing your taxes.
In addition to the federal early withdrawal penalty, as a resident of California you must pay a state penalty on early withdrawals as well. Using Form FTB 3805P, the state of California will assess a two-and-one-half percent penalty on all 401k withdrawals before age 59 1/2. This is in addition to both regular taxation and the federal 10 percent early withdrawal penalty.