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Question: My 40 year old client is applying to take a hardship withdrawal from her 401K plan. Is the distribution subject to the 10% penalty tax?
Answer: Yes, the taxable part of a 401K plan distribution is subject to the penalty tax unless one of the exceptions applies. Here are the most common exceptions:
- Death of the participant
- Disability of the participant
- Part of a series of substantially equal payments based on life expectancy
- Taken by a participant who retired from the employer sponsoring the plan at age 55 or later
- Distribution was used to pay for certain limited costs for medical care
Note that the 401K penalty tax exceptions do not include provisions for first time homebuyer or education expenses.
Hardship withdrawals may be made from a 401(k) plan only for an immediate and heavy financial need. Financial need is not an exception to the 10% penalty tax.
If the client needs money, and is worried about the income tax consequences of a hardship withdrawal, a loan may be a better option if the plan permits it. Loans are not considered taxable distributions at all. However, if the plan permits a loan
- The loan must be real and documented,
- The maximum amount of the loan is the lesser of half the vested portion of the account or $50,000, and
- The loan must be repaid under a regular amortization schedule not to exceed five years.
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