In a perfect world where everything goes according to plan, your 401(k) retirement account grows into a nice little nest egg for use during your retirement years. But sometimes well-intentioned plans take an unforeseen turn down a financially tough path. When this happens, you may find yourself looking at the funds that have accumulated in your 401(k) account and wondering if this could be the answer to your financial woes. Or you may not be experiencing money problems, but you’re looking at your 401(k) as a potential source of funds to pay for a dream vacation or buy a new home. Although you may be tempted to dip into your 401(k) funds before your retirement, unless you have an urgent need that’s precipitated by hardship, you need to to weigh the tax consequences of such a withdrawal.
401(k) Withdrawals and Taxes
If you abide by your 401(k) plan’s requirements, you’ll not only grow your retirement savings, but you’ll also reap some tax benefits along the way. Contributions to your 401(k) account are tax-deductible and tax-deferred, so you don't pay taxes on these contributions until you withdraw them after you retire. Because you did not pay taxes on this money when you deposited it into your 401(k) account, the IRS taxes it only when you make withdrawals. But if you make early withdrawals – before the earliest allowable retirement age of 59 1/2 – you’re not only taxed on the amount that you withdraw, but you may also have to pay a 10 percent penalty unless you meet certain criteria. This penalty for 401(k) early withdrawals can be substantial. After you pay the penalty, plus the taxes you owe on the withdrawn funds, you may net only half the money you withdrew. And because some 401(k) plans do not allow you to deposit into your account for six months after you make an early withdrawal, you'll pay more in income taxes during that time and you also won't be growing the funds in your 401(k) for future use.
Whether you make an early withdrawal before retirement from your 401(k) account because of hardship or any other reason, you must pay taxes on the amount you withdraw. This is not a penalty; you’ll also pay taxes on the amounts you withdraw after retirement.
In addition to the tax, you’ll pay the 10 percent penalty for early withdrawal if you’re younger than 59 1/2 years old. For example, if you make an early withdrawal of $1,000, you’ll pay the taxes on that amount, plus a $100 penalty.
Exceptions for Early Withdrawal
Even though you still have to pay income taxes on any withdrawals, you may qualify for a penalty exemption. The IRS allows some exceptions to the 10 percent penalty for early distribution of 401(k) funds to help you mitigate financial losses. Some of these exceptions include:
- If you become disabled.
- If you die and your beneficiary inherits your 401(k) account, the beneficiary does not have to pay the 10 percent penalty.
- If you no longer work for the employer that was your 401(k) plan administrator (whether you quit or you were fired or laid off), and you are at least 55 years old.
- If you withdraw less than you’re allowed as a medical expense deduction.
- If you receive payments to reduce any excess contributions you have made, or which your employer has made in matching fund contributions on your behalf.
- If you are court-ordered to pay in a domestic relations case, such as a divorce.
You may also get a break from the penalty if you can show hardship. A hardship distribution is the amount you withdraw from your 401(k) account, which your employer allows because of your immediate and heavy financial need that meets IRS guidelines and is approved by the plan administrator. Your employer can make a decision to grant you a hardship distribution after determining that you have no other reasonable financial resources or assets available to satisfy your need. Resources include insurance reimbursements, commercial loans or liquidation of your assets. If a hardship distribution is approved, you can withdraw only the amount of money to satisfy the need, which may include the funds to pay your anticipated taxes and the early withdrawal penalty.
Although administrators of retirement plans are not required to grant hardship distributions to plan participants, the IRS extends latitude to the administrators for allowing some participants to withdraw funds early. The term the IRS uses to describe the hardships that warrant such a consideration is “immediate and heavy financial need.”
The employer determines whether an employee has an immediate and heavy financial need according to the specific plan details and the employee's circumstances. Personal purchases are typically not considered financial needs, such as household goods or luxury items, so they do not meet the conditions of immediacy and severity. Further, a plan administrator cannot automatically deny that a financial need is immediate and heavy just because a plan participant could have reasonably foreseen the need.
Automatically Recognized Hardships
IRS regulations were amended in February 2017 to give employees automatic recognition of these six specific immediate and heavy financial needs, possible even if the individual could have "reasonably foreseen" them or voluntarily incurred them:
- Medical care expenses. These expenses can be for the employee or the employee's spouse, children, dependents and beneficiary.
- Home purchase and costs. Approved expenses include all costs associated with the purchase of an employee's primary residence, with the exception of regular mortgage payments.
- Eviction costs. This includes all costs or fees necessary to prevent an employee's eviction from the employee's primary residence or to prevent a foreclosure on the mortgage of that residence.
- Damage to residence. Expenses include some costs for repairing damage to an employee's primary residence.
- Educational costs. Allowable expenses include the costs of tuition, room and board, and other related educational fees. These costs must be for the next 12 months of post-secondary education, and they cover the employee and the employee's spouse, children, dependents and beneficiary.
- Funeral expenses. The expenses can cover the employee or the employee's spouse, children, dependents or beneficiary.
IRS Form 5329
If you receive an early distribution from your 401(k) account, you may be required to file IRS Form 5329, “Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts.” Each early distribution comes with its own set of circumstances, but you can refer to Form 5329 instructions to determine if you must file this form with your annual income tax return.
Victoria Lee Blackstone was formerly with Freddie Mac’s mortgage acquisition department, where she funded multi-million-dollar loan pools for primary lending institutions, worked on a mortgage fraud task force and wrote the convertible ARM section of the company’s policies and procedures manual. Currently, Blackstone is a professional writer with expertise in the fields of mortgage, finance, budgeting and tax. She is the author of more than 2,000 published works for newspapers, magazines, online publications and individual clients.