| We really ought to make this answer a "sticky" in both the Tax and Retirement forums, since this question gets asked in some form or another almost every day.
Whenever you take a withdrawal from your 401(k) you pay both federal and state income taxes on the full amount of the withdrawal, with the exception of any portion of the withdrawal which is a return to you of your after-tax contributions. For most people the vast majority of their 401(k) is made up of pre-tax contributions, employer match, and investment growth - hence for most the full amount of the withdrawal is taxable. When you get your withdrawal the company will withhold 20%. Be aware that depending on the size of the withdrawal this may push you into a higher tax bracket than you are in currently, and so come next April you may have to pay an additional amount of tax based on your actual tax bracket.
If you take a withdrawal and are under 59-1/2 years of age, in addition to income tax you will also have to pay an additional 10% early-withdrawal penalty. This is not automatically withheld - you have to pay it with your tax return in April.
There are a few exceptions to the 10% penalty, including withdrawals that are:
1. Made as part of a series of substantially equal periodic payments (made at least annually) for your life (or life expectancy) or the joint lives (or joint life expectancies) of you and your designated beneficiary (if from a qualified retirement plan, the payments must begin after separation from service) - this is known as a section 72(t) withdrawal.
2- Made because you are totally and permanently disabled, or
3- Made on or after the death of the plan participant or contract holder.
4- From a qualified retirement plan (other than an IRA) after your separation from service in or after the year you reached age 55
5- From a qualified retirement plan (other than an IRA) to an alternate payee under a qualified domestic relations order,
6- From a qualified retirement plan to the extent you have deductible medical expenses (medical expenses that exceed 7.5% of your adjusted gross income), whether or not you itemize your deductions for the year,
7- From an employer plan under a written election that provides a specific schedule for distribution of your entire interest if, as of March 1, 1986, you had separated from service and had begun receiving payments under the election
8- From an employee stock ownership plan for dividends on employer securities held by the plan, or
9- From a qualified retirement plan due to an IRS levy of the plan. | 
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