Withdrawals from a 401(k) account are difficult if you’re still employed by the company offering the 401(k). Withdrawals are allowed in certain circumstances — such as to avoid foreclosure — but are still subject to income tax and sometimes to the 10% early withdrawal penalty.
A Tax Court case from 2015 caught my attention on this subject and prompted this post. The subject of retirement account withdrawals and the 10% penalty is worthy of its own series of blog posts, but for today I’m just going to focus on the issue of foreclosure, because that was what the court case revolved around.
401(k) Withdrawals are Difficult
Tax law allows for a limited number of circumstances where a person with money in a 401(k) plan can withdraw money from their account while still employed by the company offering the plan.
“Hardship withdrawals” are allowed from 401(k) accounts. The problem is:
- You have to claim the withdrawal as taxable income, and
- You might get hit with a 10% early withdrawal penalty as well
The Tax Court case that caught my attention involved a withdrawal to help a taxpayer stave off foreclosure. The taxpayer argued to the Tax Court that the 10% early withdrawal penalty shouldn’t apply because he was going through a financial hardship.
The problem with this argument is: financial hardship is one of the ways you can get access to your 401(k) money … but financial hardship does not make you exempt from the 10% penalty.
Exemptions from the 10% Penalty
Here are some the exemptions from the 10% penalty for withdrawals from a 401(k):
- Withdrawals made after reaching age 59 1/2
- Withdrawals paid to beneficiaries after the death of the 401(k) account holder
- Withdrawals paid to someone who is disabled
- Withdrawals made by an employee who terminates employment after age 55
- Withdrawals to pay medical expenses or insurance premiums
- Withdrawals by military members called to active duty
(You can find the full list by reading Code Section 72(t)
Note that withdrawals due to financial hardship or to avoid foreclosure are not on the list. You can withdraw the money from the 401(k) for those purposes, but you can’t avoid the 10% penalty.
Note also that a different set of rules applies to withdrawals from IRAs.