Individuals faithfully building their 401k plans at work can suddenly find themselves facing a financial hardship. This leaves them wondering: Is it possible to make a 401k withdrawal without incurring a penalty? Unfortunately, the answer to this question is not that simple.
The purpose of 401k plans is to encourage individuals to save for retirement. Tax laws allow individuals to fund their plan with pre-tax dollars, and allow the money to grow on a tax-deferred basis until withdrawal. In exchange for the tax shelter that a 401k plan provides to employees, tax laws restrict the withdrawal of that money before age 59 1/2.
Some 401k plans allow employees to withdraw funds for any reason. Typically, these 401k withdrawals are limited to the elective portion of the deferral, and not any income or interest on the deferred amounts. However, these types of plans are more the exception than the rule. Generally, money can be withdrawn from a 401k account if a financial hardship exists, and only in a very limited number of situations.
The exact rules followed by each 401k plan will vary. But generally, a financial hardship is deemed to exist if a participant in the plan experiences an immediate and heavy financial burden. In addition, the participant must have no other financial means of meeting this hardship. Examples of financial hardships include:
Demonstrating true financial hardship usually requires more proof than just the repayment of money owed lenders. That is, the burden of proof must be greater than merely the inconvenience of repaying a debt.
To discourage the use of 401k plan funds for any reason other than retirement purposes, early withdrawals are subject to a 10% penalty. This means any money withdrawn from the account before age 59 1/2 may not only be subject to income taxes based on an individual's incremental tax bracket, but also a 10% penalty. The tax code, however, does allow penalty-free withdrawals if the hardship meets certain criteria.
Criteria for Withdrawals
There are three ways money can be taken from a 401k account without penalty:
Safe Harbor Provisions
The IRS also has a provision for employers to provide for a safe harbor withdrawal from a 401k plan if an immediate and heavy financial need or burden exists. The only money exempt under the safe harbor rule is that which is used to satisfy that immediate and heavy financial need. According to the IRS, the safe harbor hardship withdrawals from a 401k plan are limited to:
Hardship withdrawals or distributions are includible in gross income for federal income tax purposes, unless they consist of Roth contributions. They may also be subjected to a 10% additional tax on early distributions of elective contributions.
Prior to any kind of hardship withdrawal, a 401k plan participant is usually required to take all other possible forms of non-hardship distributions from their account. This can include loans as well as the withdrawal of after tax money in their account. As with any decision that can affect someone's financial future, it's important to consult with a 401k plan administrator and / or a tax advisor.
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