Leave that 401k alone...or else!

If I could pinpoint one common problem or misunderstanding that I am often questioned about by my clients and friends, it would be there 401k account. Most seem to understand what the basic nature of what a 401k is, which is a retirement account that typically invest a percentage of there income into stocks or mutual funds. What most of my clients and friends often don't understand is 1) that your contributions to the account are pre-tax and 2) that if you withdraw from the account there are taxing consequences.
First, lets explain the the pretax contributions. When you set up your 401k, you normally are asked what percentage of each paycheck you would like to have automaticlly deducted and contributed to your 401k. This deduction is done prior to taxes being withheld from your paycheck. So your contributions lower your taxable income. For example if your gross paycheck is $2000.00 and you chose to have 10% of that contributed to your 401k account, then every paycheck would have $200 automaticlly deducted and deposited into the 401k. This would leave you with a gross paycheck of $1800.00 and you would be only taxed on the $1800. Your federal income tax on the $1800 would likely be something like $414 and your FICA tax would be another $138, leaving you with a net paycheck or take home pay of $1248. If you had not contributed to the 401k then your net paycheck would have been $1387. So the difference is $139. Meaning you were able to save $200 for retirement that really only cost you $139 in take home pay.
The obvious purpose of the 401k is to save for your retirement. This is why the IRS will penalize you for any withdrawls from the account if you are not 59.5 years old. This penalty is 10% of the withdrawl. The other consequence of any withdrawls prior to being 59.5 is that you now have to include the withdrawls as income on your tax return and since it was contributed to the 401k account prior to being taxed, it will now become taxable, often putting you into a higher tax bracket and resulting in a 1040 tax return with a balance due. Since most people do not understand these consequences they also do not prepare for them and now have a tax liability or rather a tax debt that they cannot pay.
The IRS has limited options for resolving this situation. You can either requested an installment agreement to repay the debt over time or depending on your financial situation you may be able to be placed in a financial hardship know as Currently Not Collectable. If you chose to ignore the sitatution then eventually the IRS will enforce collection of the liability through a "wage levy" a "bank levy" or both. They IRS will also likely file a tax lien against your social security number.
The moral of this is to leave your 401k account alone and avoid any withdrawls from the account. If you find yourself in a situation where you need to access the funds, you should try to borrow against the account rather than withdrawl from the account. Perferrably, you should simply leave the account alone until after you are 59.5, also prior to making any loans or withdraws from your 401k accounts please consult your tax adviser, or a "Tax Expert".