Growing numbers of people in these difficult economic times make a 401k hardship distribution and liquidate part or all of their retirement savings. Sometimes they decide to take a portion of their savings to invest in a house or in their education. Other times however, they are forced to use their tax advantaged retirement plan as an alternative source of money to pay bills when faced with a job layoff, a medical emergency, or some other unexpected personal situation rather than face extreme choices like declaring personal bankruptcy.
A 401k hardship distribution should be your “financial option” of last resort.
There are three ways the savings you have accumulated in a qualified retirement program like a 401k plan can be withdrawn:
- Through a draw down of money (called a qualified distribution) when you have reached the plan’s retirement age (for example, 59 1/2 years of age).
- The temporary borrowing of funds via a 401k loan, depends on provisions written into the retirement plan agreement.
- Draw down money from a qualified retirement plan is to seek what is known as a 401k hardship distribution.
A 401k hardship distribution has serious consequences and should only be made when few other options are available to resolve your financial situation. The distribution cannot exceed a participant’s total elective contributions and earnings. Details permitting a 401k hardship like a plan loan must be provided for in the plan documentation. In fact, Congress passed the Pension Protection Act of 2006 regulating the use of a 401k hardship distribution that relate to medical issues, tuition costs, and funeral expenses for the primary beneficiary of a plan account just like that of the account holder.
What are qualifying expenses for a 401k hardship distribution?
Various types of expenses have been categorized as qualified reasons for a 401k hardship distribution including:
- medical expenses that exceed 7.5% of the taxpayer’s adjusted gross income (AGI)
- first-time home buyer purchases up to $10,000
- qualified higher education expenses
- a medically-determinable disability that can interferes with gainful employment, is expected to result in death, or could continue for an indefinite period
- expenses that would prevent foreclosure of a principal residence
- expenses related to the repair of major damages (casualty) to the principle residence
Is a hardship distribution taxable in the current year?
The distribution of funds from a retirement savings plan like a 401k or traditional IRA is never tax-free; the distribution is taxed along with other income at the marginal tax rate in the tax year the distribution takes place. Qualified distributions typically occur after the age of retirement when theoretically a taxpayer no longer receives regular wages and pays lower marginal income tax rates. Non-qualified distributions such as early or premature distributions typically happen before the plan’s retirement age; they are subject to both the income tax rate and to a 10% penalty. When a 401k hardship distribution is taken, income taxes are still owed, but when allowed, is exempt from the 10% penalty.
How do I claim a hardship distribution exemption?
Seek professional tax advice when you receive an IRS Form 1099-R, Distribution From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. The Distribution code(s) that appears in Box 7 on the income document describes circumstances that relate to the distribution. An adjacent area can be checked if the plan is IRA, SEP, or SIMPLE. A code 7 in the box indicates a normal or qualified distribution; distribution code 2 signifies an early distribution where exceptions apply such as a Roth IRA conversion, results of an IRS levy, etc. or other circumstances not related to Code 1 – early distribution, Code 3 – disability, or Code 4 – death. Your tax professional interpret these codes and, where appropriate, complete additional tax forms supporting your claim for a 401k hardship distribution exempted from the 10% tax penalty.