If you're allowed to take a distribution from your 401(k), you can pay the Internal Revenue Service -- or anyone else -- with the proceeds. When you do take out money, it isn't treated differently for income tax purposes just because you're paying your taxes with it. You might, however, get a small break if the IRS is taking money out of a 401(k) with a levy.
If you're at least 59 1/2 years old, your 401(k) plan is yours to use as you see fit whenever you want, and that includes taking out money if you want to pay off Uncle Sam. If you haven't reached the magic age yet, you can only take money out of your 401(k) plan under certain circumstances -- for example, after you've left your job, suffered a permanent disability or experienced a financial hardship. The IRS does state, in its general distribution rules for 401(k) plans, that amounts drawn due to financial hardship "may include any amounts necessary to pay any federal, state, or local income taxes or penalties reasonably anticipated to result from the distribution." However, 401(k) plans are not required to allow such hardship distributions -- some plans do and some don't.
Just because you're taking money out of your 401(k) plan to pay your taxes doesn't mean you get out of the taxes on the distribution. For example, say you're taking out $9,000 to pay the IRS. If you fall in the 25 percent tax bracket, you're going to owe an extra $2,250 in income taxes in the year you took the money out, because the withdrawal counts as taxable income.
Early Withdrawal Penalty
If you're under 59 1/2, you might also be slapped with a 10 percent additional tax on your 401(k) distribution because you're taking an early withdrawal. For example, if you take out $9,000 to pay the IRS, you're going to have to pay an extra $900 on top of the income taxes. If you're over 59 1/2, permanently disabled or you retired after you turned 55, you don't have to pay the penalty.
IRS Levy Exception
If the IRS levies your 401(k) plan specifically, any distributions used to pay off the levy aren't hit with the 10 percent early withdrawal penalty. But, that doesn't mean the IRS will just take the money out unannounced. Instead, you receive a notice of the tax due and the IRS informs you of its intent to levy your 401(k) plan before taking the money, so you have a chance to pay it with other funds if you want. However, if the IRS just sends you a tax bill, or levies other property but not your 401(k) plan, you don't have an exception to the early withdrawal penalty if you use 401(k) plan money to pay it off. It only works if the IRS is the one to take the money out.