I plan on going back to school full time next year, meaning I will quit my job (zero income next year). I am thinking about putting everything I can legally into my company's 401k plan, then withdraw with a penalty next year, thinking that my tax bracket then would be lower (again, zero salary income). I plan on withdrawing instead of borrowing because for other reasons (health, etc) I don't plan on keeping it in the plan on the long run.
I want to know if my thinking is correct here:
Am I paying tax according to my next year tax bracket when I withdraw?
I pay tax, plus a 10% penalty, and that's it (sounds like my lower tax bracket covers that already doesn't it?)
I can withdraw multiple times (20% of my savings next year, 20% the year next, and so on) correct?
(I understand I can also claim hardship, but with the savings I have in the bank I am not sure I can/want to).
I think you would be much better off rolling your 401k over to an IRA after you quit your job. It's a lot simpler and it can save you a lot of money. For starters, it's a lot easier to get the money out of an IRA. There are fairly strict rules governing when you can take an early distribution from a 401k. These rules do not apply to IRAs. In addition, there is no 10% penalty on early distributions from an IRA used to pay for medical insurance and higher education (including room and board if you're at least a half time student). Not so with early distributions from a 401k.
You have the basic idea right - a premature distribution gets hit with a
10% penalty plus income taxes. If your income tax rate is zero in 2010, or whenever you take the money out, then there's just the penalty. Keep in mind that your state may also have a penalty for early distributions (here in CA it's 2.5%).
So you'd need to game that out and see if there's a net benefit to doing a max-deferral to the 401k this year and taking the money out in a later low-tax year, despite paying the penalties.
Another option could be moving the 401k dollars to a Roth IRA. If you can wait 5 years from the conversion you might avoid the penalty when you do take the money out. And whatever you leave behind grows tax-free. Check the rules on Roth IRA distributions to see if that could work:
To Tad's point, once you roll the 401(k) to an IRA, see how much you need for school. Then convert to Roth whatever amount will fill up your zero bracket, i.e. std deduction and exemption.
If you weren't working, you couldn't borrow from it, anyway.
401k loans typically have to be paid back in full upon termination, else the loan is converted into an early distribution and taxes and penalties are due.
Again, that's only if you're still employed.
Instead, consider maxing out the 401k and then rolling the proceeds into an IRA after you leave the employer. Then, you may use IRA money *penalty-free* for qualified education expenses. See IRS pub 970:
Moreover, if you're going from higher earnings to a period of very much lower (zero) earnings, that may also be a great opportunity to convert the money over to a Roth IRA (well, any that you don't use for qualified education expenses).
That's a good point, I forgot that you can use the money for qualified education expenses for yourself. So the 10% penalty might not apply anyway, even without doing a Roth conversion and waiting.
Assuming your employer will let you roll the money from your 401(k) into your personal IRA, you can avoid the premature distribution penalty if the money is used for qualified higher education expenses for you, your spouse or your dependents.
The trick is going to be WHEN you can roll the money into your IRA. Years ago the IRS got wise to a lot of the ways people could get at their 401k money and they've done everything they can to shut it down. Consider this:
A qualified plan has to have a plan document. A qualified plan is almost always subject to top heavy testing. A qualified plan must have eligibility requirements that define who can participate and when they can get in. Most plan define eligibility for employment based on certain income and time limits.
So if your plan says that anyone that works 1,000 hours in a calendar year and earns $5,000 or more is eligible to participate AND you leave service today, your plan may not be able to make a distribution to you because you COULD get rehired with enough time left in the year to make you eligible to participate AND since you were a prior participant if they had to let you back in right away you'd have to repay the money you took out OR ELSE the plan may fail the top heavy testing rules.
This is why most plans have a waiting period of some sort before they will provide distributions to ex-employees.
Of course the same issues will apply when you try to close the plan - you may be subject to a waiting period of some sort. I would suggest that you speak with HR and GET IN WRITING what the plan says about:
1 - how soon you can get your money out;
2 - what happens if you get rehired.
Then look to see if you'll get your money in time to pay for school. And if possible, rollover the money to your IRA THEN take the money out so you can use the exception to the penalty.
Lastly, if you've enough money left in the IRA that you don't need for school FOR THE CURRENT period, consider transferring as much of it as you can to a ROTH IRA - this would let you access the money in future years essentially tax free as long as you don't take out earnings.
I also think it would behoove you to speak with a tax professional and pay for an hour or two of good advice and analysis before you do any of this.
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