401(k) Withdrawal

According the Internal Revenue Service (IRS) document 401(k) Resource Guide - Plan Participants - General Distribution Rules, distribution of elective deferrals cannot be made until:

• You die, become disabled, or otherwise have a severance from employment.
• The plan terminates and no successor defined contribution plan is established or maintained by the employer.
• You reach age 59½ or incur a financial hardship.

In general, if you withdraw money from a traditional individual retirement account such as a 401(k) or other qualified retirement plan before you turn age 59½, you are subject to penalty of 10%. Congress calls these withdrawals "distributions," and for the sake of consistency we will use that term here. The distribution is also included in your taxable income. The 10% tax is in addition to regular income taxes. Note that the associated penalties and taxes are applied at the time of distribution, so even if you plan to gift the proceeds later on, you will still be liable for the penalties and applicable taxes.

You can avoid this additional tax penalty if you meet certain criteria, but you cannot avoid including a 410(k) distribution from your taxable income. Some distributions can be made without penalty, but these usually require a true financial hardship.

Here is more information about hardship-based distributions.

Financial hardship distribution

Congress permits two types of hardship distributions. 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 § 72(t) of US Code. With this, you pay applicable income taxes but not an early distribution penalty. As mentioned, Congress created guidelines for 401(k) plans, but gave employers a great amount of leeway to create their own, more stringent rules. Therefore, although hardship distributions are allowed by Congress, your employer may have created different rules for your plan. Contact your 401(k) plan administrator and review the rules for your plan. If you do not know how to reach your 401(k) administrator, call your human resources or payroll department who will be able to direct you accurately.

Congress permits financial hardship distributions 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 distribution 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).

Here, if a hardship distribution is permitted in your 401(k) plan, and you can argue to the 401(k) plan administrator that the distribution is necessary for you to prevent eviction or foreclosure on your home (or one of the other reasons listed in the bullet-points above, then you can receive a distribution without paying the 10% penalty tax.

If you have already received a distribution from your 401(k) and paid the 10% penalty tax, I do not know of a way to dispute this. (Readers, please offer clarification below.)

Regarding the loan, you must treat the outstanding balance of the loan as a distribution on the date of the transaction, according to IRS publication Publication 575: Pension and Annuity Income.

Rollover in an IRA

You mentioned rolling your 401(k) into an IRA. If you roll the balance of the 401(k) into an IRA, you will pay zero dollars now in penalties or taxes related to the rollover. You can move these funds into an account type of your choice, such as CDs, money market, a fund at a brokerage that either you or a stock broker control -- really you are only limited by your imagination. See the IRS document Publication 590 to learn more about the rollover rules.

It is unclear in your message if you are taking a distribution from your 401(k), IRA, or both. See the IRS document Publication 590, Individual Retirement Arrangements (IRAs) to learn more about IRAs in general, and the rules for distributions in particular.

Income tax and IRA or 401(k) distribution

You will receive a Form 1099-R from the plan administrator by January 31 of the year following the year of distribution. Form 1099-R is an IRS form reporting the gross distribution paid during the given tax year, the amount of the distribution that is taxable, the federal income tax that has been withheld, the contributions made to the investment or premiums paid, and a code that represents the type of distributions made to the holder of the plan.

See IRS Publication 575: Pension and Annuity Income for instructions on how to report your 401(k) or IRA distribution on your 1040 form. To report the tax on early distributions, a participant may have to file Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts. See the Form 5329 instructions for additional information about this tax.

I hope the information provided helps you Find. Learn. Save.

Best,

Bill

Bills.com