When you placed assets into your 401k, you probably did it with the best intentions, planning on leaving the account untapped until you reached retirement age. An extended disability that took you out of the work force can derail even the best intentions: Disability payments, insurance and savings may not be enough to sustain you through a long-term disability. Turning to your 401k may seem like an easy way to relax the financial squeeze, but you may incur tax penalties if your disability doesn't qualify.
The Internal Revenue Service doesn't regulate 401k plans as strictly as it does traditional individual retirement accounts. Instead, plan administrators are allowed to set guidelines on many aspects of plan maintenance, including hardship distributions. Many plans allow you to take hardship distributions -- withdrawals made under extreme financial conditions -- without incurring any additional taxes. Depending upon the details of your 401k, you may have to prove your disabled status to qualify for such a hardship distribution. If your plan handles hardship distributions with the same rules as an IRA does, you'll need to be permanently disabled, receiving Social Security disability insurance, to qualify.
Taxes on 401k Distributions
If you don't qualify for a hardship exemption because of your disability, the IRS taxes all distributions you make from your 401k before you turn 59 1/2 with a 10 percent excise tax on the amount of the distribution. Because you make contributions to most 401k plans, though not Roth 401ks, on a pretax basis, you defer taxation on that income until you receive it. The IRS taxes all distributions, whether hardship, premature or qualifying, at regular income tax rates for your tax bracket. The silver lining? It's likely that because of your disability, you're in a lower tax bracket than you were when you earned the money.
If you suffer from a short-term disability that won't qualify you for a hardship distribution and you intend to return to your former job when you recover, you may be able to access 401k funds through a 401k loan. As with other rules regarding 401ks, your plan administrator's rules govern the process and the amount you may be allowed to borrow from your 401k. Some plans don't allow loans. If your plan allows it, you may be able to borrow up to $50,000 from your own contributions, although your plan may provide a lower limit. When you return to work, you'll begin repaying the loan, with interest charges that also go into your account, with an automatic payroll deduction. Should you leave your job before paying off the loan, you may be required to pay back remaining balance immediately.
The IRS also allows you to make even, significant distributions from your 401k as if it were an annuity. To do this, you'll need to meet with an accountant who will use IRS-generated actuarial tables to determine your life expectancy. Your 401k balance may be paid in equal, annual installments without incurring an excise tax penalty, based upon your projected lifespan. This option usually doesn't allow you to access large amounts each year unless your 401k was very large or your remaining projected lifespan is short.
- IRS.gov: 401k Resource Guide - Plan Participants - General Distribution Rules
- IRS.gov: 401k Resource Guide - Plan Sponsors - General Distribution Rules
- Bankrate; Retiring Early on a 401k/IRA without Penalty; Laura Bruce; May 2001
- Bankrate; How to Take Penalty-Free 401k, IRA Withdrawals; Sheyna Steiner; March 2010
- "Kiplinger"; The Pitfalls of a 401k Loan; Kathryn A. Walson; October 2008