Hardships may avoid 401k tax implications
If you become totally and permanently disabled, you may receive funds from your 401(k) plan without penalty. The folks at the Social Security Administration set the bar for this determination, and it’s a pretty high bar. In fact, if it’s the case for you, it’s likely that someone else is reading this page for you to find out what to do. The principle behind this rule is simply that the IRS doesn’t want to tax someone who is in a dire situation that will not improve.
A hardship distribution is an alternative for getting money out of your retirement plan. Not all employers allow hardship withdrawals, even though IRS code allows it. And by “allows it,” we mean that you can have whatever is left after taxes and a hefty 10% penalty.
If you haven’t reached the age of 59 ½, then penalties and ordinary income tax will still be due on any sums you withdraw from your account. So even if you are experiencing severe financial or medical distress, the most the government will allow is that you can take some money now, instead of later. But you will still be penalized for it.
Congress devised these tax rules for 401(k) accounts in order to emphasize the importance of individual responsibility for retirement savings and as a way of preventing spurious withdrawals for ordinary wants and whims. At an income tax bracket of 30%, anything you buy with the proceeds from a premature withdrawal from a retirement account will require liquidating about 166% of the purchase price. (Assuming a ten percent penalty and a thirty percent tax on the ordinary income of the original withdrawal amount.)
You may avoid the tax penalty if you’re very close to retirement age anyway.
Separation from service after age 55 is another path to get money out of your 401(k). Do it right, and you won’t have to pay extra for it.
Filed under 401(k) News