The 401(k) account that you set up for a financially secure future is not set up to protect you from your obligation to support the federal government's budget, which is imposed through the tax code. Consequently, while the Tax Policy Center reports that 61 percent of Americans paid no federal income tax in 2020, it's the U.S. tax legislation and enforcement processes that determines who must pay taxes and what a certain citizen's tax bill will be.
Based on current legislation, if you fail to comply with the tax code, your retirement fund is not protected from what may seem to some as the heavy hand of government. This is true despite recent changes to the 401(k) in terms of the plan's design, administration and compliance due to the SECURE Act of 2019.
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Creditor Claims and Your 401(k)
According to the IRS, in most cases, your retirement plan is safe from claims by creditors to whom you owe money. The IRS, however, is not a typical creditor; it's a "super creditor." If you owe back taxes and penalties to the U.S. government, the IRS may attach a levy to the funds in your retirement account – Qualified Pension, Profit Sharing and Stock Bonus Plans under ERISA; IRAs, Retirement Plans for the Self-Employed and the Thrift Savings Plan.
Read more: Legal Protection for a 401k vs. IRA
IRS Collection Actions
If you don't pay your taxes on time, the IRS can take a variety of actions, including imposing a federal tax lien and a seizure of your property.
Federal Tax Lien
The IRS can register a legal claim against property, including your 401(k), in the form of a federal tax lien. This lien is a legal claim against all of your current and future property that's created when you don't pay your first bill for taxes due. The property subject to the lien includes your home and car as well as any property to which you have current and future rights.
Consider also: Can Anyone Put a Lien on My Tax Refund?
IRS Levy 401(k)
Whereas a federal tax lien is a legal claim that's registered against your property, a levy is the actual legal seizure of your property. This property may include your house and car or your rights to property, including your wages or salary and other income, bank account(s), retirement account(s) or Social Security payments. The levy remains in force until your tax debt, including related penalties, is satisfied.
Consider also: Is a 401k the Same as an IRA for Filing Taxes?
401(k) and Back Taxes, Penalties
If you owe back taxes, the IRS may seize – levy – the funds in your 401(k) account assuming that your retirement plan allows you to take a distribution from the account. If it does, the IRS will seize your 401(k) to settle your tax debt by paying it with the funds in which you have a vested right. If, however, a restriction of your retirement plan does not allow you to take distributions from the account, the IRS is unable to levy the funds in the account.
From the perspective of the Internal Revenue Service, the agency's withdrawal of the cash from your 401(k) account is classified as a hardship withdrawal in that it's an "immediate and heavy financial need." Your employer, however, must have structured your plan to account for hardship withdrawals.
What's more, your plan must consider the IRS levy to be a "hardship exception" to the 10 percent early withdrawal penalty. For this to occur, the IRS must place a levy on the 401(k) plan in question, rather than place a general levy on all of your assets. If you are age 59 1/2 or older, the withdrawal of funds from your 401(k) occurs without penalty.