It's a safe bet that tapping into your retirement nest egg early is not your first choice even when facing financial hardship. Unfortunately, sometimes withdrawing money from an IRA, 401k or similar plan is the only choice. Normally the IRS imposes a 10 percent penalty for early withdrawals. However, you may be able to withdraw funds without penalty for certain reasons.
You are supposed to leave money in a 401k or Individual Retirement Account until you reach 59 1/2 years of age. Funds withdrawn early are subject to ordinary income taxes plus a 10 percent penalty tax. This restriction does not apply to contributions made to a Roth IRA or Roth 401K account, which may be withdrawn at any time. However, a Roth account must be open for at least five years even if you are past the age limit, or taking out earnings will be considered an early withdrawal.
The IRS definition of hardship is fairly limited. The financial need must be severe and urgent. Beyond this general principle, hardship withdrawals that may be exempt from the penalty tax are limited to a few specific categories. A hardship distribution may not exceed the amount of the financial need plus applicable federal and other taxes. The funds may not be paid back at a later time. If you have an IRA, you can get the penalty tax waived for hardship distributions that meet IRS guidelines. However, that is not necessarily true of 401k plans. With a 401k, the plan may or it may not allow withdrawals under a hardship rule at all, or it may not allow a waiver of the penalty tax. The plan provider and/or sponsoring employer is allowed to make that determination.
Health Related Hardship
All IRAs and many 401k plans allow waiver of the 10 percent penalty tax for qualified health related reasons, although you still must pay income taxes on the withdrawn money. If your health insurance does not reimburse medical bills exceeding 7.5 percent of your adjusted gross income, you can use retirement plan funds to pay the amount in excess of 7.5 percent. You can also pay health insurance premiums while out of work if you receive unemployment benefits for at least 12 weeks. If you die, the beneficiary can withdraw the money with no penalty unless the beneficiary is a spouse who treats the plan as her own. Finally, if you are permanently and completely disabled, the penalty tax can be waived.
Although there are other allowed hardship distribution categories, 401k plans often will not waive the penalty tax for them. One exception is the purchase or repair of a home (or to prevent eviction). However, you will probably have to exhaust any options you have for borrowing from a 401k first to avoid the penalty. You may withdraw money to pay higher education expenses, to pay funeral costs for a family member or to pay for an IRS tax levy. You can set up a series of substantially equal annual payments before you reach age 59 1/2 to provide income. Such an arrangement must be for at least five years or until you turn 59 1/2, whichever is the longer time period.
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