401k plans are created and managed by employers to assist their employees in saving for retirement. These plans offer the ability to make pretax contributions and allow employers to contribute on their employee's behalf. The Internal Revenue Service sets rules for when account holders can withdraw money from their 401k plans and how those withdrawals are taxed and penalized.
When Can Money Be Withdrawn?
The IRS rules only permit distributions from 401k plans under limited circumstances, unlike IRAs which allow withdrawals to be taken at any time for any reason, although they may be subject to additional taxes and penalties. Money can only be taken from a 401k plan if the account holder dies, suffers a permanent disability, leaves the company, the plan is ended and not replaced by another plan by the employer, the account holder turns 59 1/2 or has a financial hardship. Not all permitted withdrawals are qualified withdrawals. If you take money out before age 59 1/2, you will have to pay a 10 percent early withdrawal penalty unless you have a permanent disability or left employment after turning 55 years old.
Hardship Withdrawals
401k plans are permitted by IRS regulations to allow withdrawals in the event of a financial hardship. A financial hardship occurs when an immediate financial need of the account holder cannot be satisfied by other financial resources. For example, buying a flat-screen TV would usually not qualify while paying for medical expenses would usually count. Other examples the IRS lists as likely qualifying include paying tuition for college expenses, purchasing a home, avoiding eviction or covering funeral expenses. These withdrawals are limited to the amount of the hardship plus income taxes and the 10 percent early withdrawal penalty on the hardship withdrawal.
Taxes and Penalties
Qualified withdrawals from 401k plans must be included in the account holder's taxable income during the year that the withdrawal is taken. The amount is then taxed as any other income that year. To report the income, taxpayers will receive a form 1099-R to document the withdrawal and must use form 1040 or 1040A to file taxes. If a nonqualified withdrawal is taken, including a hardship withdrawal, a 10 percent penalty applies to the withdrawal on top of any income taxes owed. To document this penalty, taxpayers must use form 5329 and file taxes using form 1040.
