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.
Many 401(k) plans allow employees to make a hardship withdrawal because of immediate and heavy financial needs. Generally, hardship distributions from a 401(k) plan 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.
A hardship withdrawal is not like taking a loan from your 401(k) account. The withdrawal may be difficult to get, and costly if you receive it. Remember, your 401(k) is meant to provide retirement income. It should be a last-resort source of cash for expenses before then. IRS rules allow plan withdrawals in a limited number of hardship situations. To further discourage early withdrawals, in some cases the IRS imposes a hefty financial penalty.
Two types of hardship withdrawals are permitted from 401(k) plans. One is called a financial hardship withdrawal. It is subject to applicable income taxes and a 10% early withdrawal penalty 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.
Financial hardship withdrawals are allowed for the following reasons:
- To buy a primary residence
- To prevent foreclosure or eviction from your home
- To pay college tuition for yourself or a dependent, provided the tuition is due within the next 12 months
- To pay un-reimbursed medical expenses for you or your dependents
You may qualify to take a penalty-free withdrawal if you meet one of the following exceptions:
- You become totally disabled.
- You are in debt for medical expenses that exceed 7.5% of your adjusted gross income.
- You are required by court order to give the money to your divorced spouse, a child, or a dependent.
- You are separated from service (through permanent layoff, termination, quitting or taking early retirement) in the year you turn 55, or later.
- You are separated from service and you have set up a payment schedule to withdraw money in substantially equal amounts over the course of your life expectancy. (Once you begin taking this kind of distribution you are required to continue for five years or until you reach age 59½, whichever is longer.)
Remember, employers are not required to offer either type of hardship withdrawal, so you should check with your employer to see which type, if any, is available to you.
For more information, see the IRS’s 401(k) Resource Guide.
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