Early withdrawn 401k funds taken this year while 1099R is sent next, which return are penalties filed 2007 or 2008? Also, the funds were used to purchase a home. Will interest deductions offset penalties? Amount withdrawn is 15,000. Cost of home is 175,000. What are ways I can offset the penalties?

You'll receive a 1099R form in January showing your withdrawals in 2007. You use this to complete your 1040 form for the 2007 tax year, which is due by April 15 2008.

The penalty that you will pay is 10% of the 15K, or $1,500. Assuming you are in the 20% income tax racket, you also owe 20% of the $15K withdrawal as regular income tax. Hence your total payment to Uncle Sam because of the withdrawal is $4500. I don't know how much interest you will have paid in 2007 on your mortgage, but at the 20% tax rate that $4500 in additional taxes would require $22,500 in deductions in order to "break even."

Ebaines explains it VERY well.

It would have been better if you had either borrowed the money from the 401K, or did a rollover to a rollover IRA, then did the withdrawal from the IRA for the down payment.

Had you done the withdrawal from the IRA, $10,000 of the withdrawal would have been EXEMPT from the 10% Early Withdrawal Penalty.

Unfortunately, that exemption only applies to withdrawals from IRAs, NOT 401Ks.