Making Sense of 401(k) Hardship Withdrawal

How Can I Take a 401(k) Withdrawal Without a Penalty?

I read that at age 55 I can withdraw my 401(k) without penalty as long as I am leaving my job. Is this true for all 401(k) plans? Are there any specific reasons one has to have for withdrawal without penalty?  I need to use the funds to pay off bills and debts.

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  • Congress permits two types of 401(k) hardship distributions.
  • File a Form 5329 to report the tax on early distributions.
  • Your plan administrator will send you a Form 1099-R.

How Can I Take a 401(k) Withdrawal Without a Penalty?

A 401(k) plan is a type of tax-qualified deferred compensation plan in which an employee can elect to have the employer contribute a portion of his or her cash wages to the plan on a pre-tax basis. These deferred wages (commonly referred to as elective deferrals) are not subject to income tax withholding at the time of deferral, and they are not reflected on your Form 1040 since they were not included in the taxable wages on your Form W-2.

However, they are included as wages subject to Social Security, Medicare, and federal unemployment taxes.

Some plans allow employees to make a 401(k) hardship withdrawal because of immediate and heavy financial needs. Generally, 401(k) hardship distributions are limited to the amount of the employee’s elective deferrals only, and do not include any income earned on the deferred amounts. Hardship distributions are not treated as eligible rollover distributions.

Borrowing to Solve a Debt Problem?

If debt problems are the reason you are looking to take out money from your 401(k), get a no-cost, no obligation analysis of your debt options from a pre-screened specialist. It makes sense to evaluate your debt options in parallel with exploring 401(k) hardship qualifications.

401(k) Hardship Withdrawal Basics

A 401(k) hardship withdrawal is not like taking a loan from your 401(k) account. The withdrawal may be difficult to get, and costly to receive. Your 401(k) is intended to provide retirement income and should be a last-resort source of cash for expenses. IRS rules allow plan withdrawals (called distributions) in a limited number of hardship situations. To further discourage early withdrawals, Congress wrote harsh rules to impose a penalty tax in many situations.

Congress allowed two types of hardship withdrawals in 401(k) and other deferred-tax retirement savings plans. One subject to applicable income taxes plus a 10% early withdrawal penalty tax if you are younger than 59½. The other is a penalty-free withdrawal made under Section 72(t) of the Internal Revenue Code. With this, you pay applicable income taxes but not an early withdrawal penalty tax.

You may receive a 401(k) hardship distribution because of an “immediate and heavy financial need” and the distribution “is necessary to satisfy that financial need.” Let's look at the rules for penalty and no-penalty distributions, as found in IRS document Topic 558 and the IRS 401(k) Resource Guide - Plan Participants - General Distribution Rules. Refer to both of these documents for clarifications on the rule below.

Distributions Subject to a 10% Penalty Tax if You Are Less Than Age 59½

According to the IRS, the following reasons may be allowed by your plan's administrator for a 401(k) distribution:

  • Expenses for medical care previously incurred by the employee, the employee’s spouse, or any dependents of the employee or necessary for these persons to obtain medical care;
  • Costs directly related to the purchase of a principal residence for the employee (excluding mortgage payments);
  • Payment of tuition, related educational fees, and room and board expenses, for the next 12 months of postsecondary education for the employee, or the employee’s spouse, children, or dependents;
  • Payments necessary to prevent the eviction of the employee from the employee’s principal residence or foreclosure on the mortgage on that residence;
  • Funeral expenses; or
  • Certain expenses relating to the repair of damage to the employee’s principal residence.

Distributions Exempt From a 10% Penalty Tax

According to the IRS, the following reasons may be used for a penalty-free 401(k) distribution:

  • Distributions made to your beneficiary or estate on or after your death.
  • Distributions made because you are totally and permanently disabled.
  • Distributions made as part of a series of substantially equal periodic payments over your life expectancy or the life expectancies of you and your designated beneficiary. If these distributions are from a qualified plan other than an IRA, you must separate from service with this employer before the payments begin for this exception to apply.
  • Distributions to the extent you have deductible medical expenses that exceed 10% of your adjusted gross income (7.5% if you or your spouse is 65 or over) whether or not you itemize your deductions for the year. The 7.5% limitation is a temporary exemption from January 1, 2013 to December 31, 2016 for individuals age 65 and older and their spouses. For additional information, see IRS Topic 502.
  • Distributions made due to an IRS levy of the plan under section 6331.
  • Distributions that are qualified reservist distributions. Generally, these are distributions made to individuals that are called to active duty for at least 180 days after September 11, 2001.
  • For 401(k)s and similar plans (but not IRAs), these three exceptions also apply:
    • Distributions made to you after you separated from service with your employer if the separation occurred in or after the year you reached age 55, or distributions made from a qualified governmental defined benefit plan if you were a qualified public safety employee (State or local government) who separated from service on or after you reached age 50.
    • Distributions made to an alternate payee under a qualified domestic relations order, and
    • Distributions of dividends from employee stock ownership plans.

Plan administrators and employers are not required to offer either type of 401(k) hardship withdrawal, so check with your administrator to learn which type of distribution, if any, is available to you.

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For more information, see the IRS’s 401(k) Resource Guide.

I hope this information helps you Find. Learn & Save.

Best,

Bill

Bills.com

178 Comments

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  • SH
    Jun, 2012
    sharlotte
    Can I get a hardship loan to bury a dependent?
    1 Votes

    • BA
      Jun, 2012
      Bill
      You should speak with your 401K plan administrator. I don't see a hardship exception for burying a dependent, but it is possible that it could loosely fit into another approved category.
      0 Votes

  • MB
    Feb, 2012
    Marsha
    We took a one-time withdrawal from my husband's 401K at age 59 1/2. We paid the 20% taxes at the time of distribution. My question is: does this allowed withdrawal count solely as income? We now owe an additional $2400 in Federal and $3300 in state taxes that we didn't realize we would owe. We thought that the 20% we paid up front would be all we owed. Do we have to pay the full amount of these additional taxes all at once or is there an allowable way to spread this over time without additional penalties and interest?
    1 Votes

    • BA
      Feb, 2012
      Bill
      The income was taxable and the 20% you paid did not fully cover your tax obligation. You can set up a payment plan with both the state and the IRS, but interest and penalties continue to accrue. I know of no way for you to avoid extra interest, other than paying the bill in full now.
      2 Votes

  • PS
    Feb, 2012
    PC
    Just received a letter from the IRS stating they have been trying to contact me since April 2010 about a tax issue, and that I now owe over 4k in taxes due in 3 weeks!!! I think this has something to do with my 401k I cashed out in 2009 when I lost my job, I was told by HR Block when I did my taxes it was a hardship and would not be required to file it. What can I do?
    0 Votes

    • BA
      Feb, 2012
      Bill
      You received incorrect information from your tax preparer. Whenever a person receives any distribution from a 401(k) or similar tax-deferred retirement plan, you must show that distribution in your income tax return. Consult with your tax preparer immediately to decide a strategy for resolving this issue.

      You may be able to get the penalties the IRS is charging you waived, if you can prove that you were following a professional tax preparer's advice. Also, if you can't afford to pay the IRS in three weeks, you can set up a long-term IRS payment plan that will protect you from a wage garnishment or bank levy.
      1 Votes

  • DH
    Feb, 2012
    Dee
    My husband's job changed hands and he chose to withdraw his 401K so that we could pay the exhorbitant bills for my cancer care. Our medical deductions did exceed the 7.5% and yet, this tax software I'm using keeps kicking it out and saying we still owe a 10% penalty. Am I missing something here?
    0 Votes

    • BA
      Feb, 2012
      Bill
      I cannot explain the behavior of your tax preparation software. Bills.com relies on the documents published by the IRS and the tax code when writing tax related articles and answering questions. See IRS 401(k) Resource Guide - Plan Participants - General Distribution Rules for a discussion of the medical exception to the 10% tax rule.
      1 Votes

    • DH
      Feb, 2012
      Dee
      Thank you for the reference. I guess my question should be...should we have indicated to the PAYER that the withdrawal was for medical expenses? Do we have to have a particular Distribution Code on the 1099-R for it to be recognized as allowable? I wish I had to money to go to a tax preparer, but I don't. I'm so confused and frustrated trying to make some kind of silver lining out of this dark cloud of last year... Thanks
      0 Votes

    • BA
      Feb, 2012
      Bill
      Yes, you need to indicate on the distribution application that you meet the "deemed necessary" rule for a medical hardship. See IRS Retirement Plans FAQs regarding Hardship Distributions to learn more.
      0 Votes

  • LF
    Feb, 2012
    Leo
    I was wrongly accused by my ex of family violence, but the case later dismissed by DA when they had no evidences going into trial a year ago; however, it cost me close to $35k in attorney's fees to keep up with the process and prepared for trial. Having spent another $20k in my divorce case; I was forced to tap into my former employer 401k and borrowed $15k from my account, which I used as final payments to my three attorneys prior to the trial day. During this time I made three payments before defaulting. Tried to catch up soon after but my 401k administrator returned my payments for I had violated the conditions of the loan. I received a 1099-R last week for the total amount distributed or borrowed. The inability to borrowing this money to hire these defense attorneys, would had spelled conviction of domestic violence for me, and therefore; destroying my personal and professional life. My question is: would these be valid reasons for considering my case a “financial hardship” so the 10% penalties would not apply? Your reply will be greatly appreciated and thanks.
    0 Votes

    • BA
      Feb, 2012
      Bill
      Effective defense lawyers are expensive, but ineffective ones are even more expensive.

      Paying one's criminal or civil defense lawyer is not one of the hardships Congress included when it wrote the 401(k) code. Review the list of qualifying hardships above, and follow the link to the IRS page that explains qualifying hardships in greater depth.
      0 Votes