When you invest in a 401(k), you're supposed to keep your money in the account until you turn 59 1/2. If you want to take out your money early, you need to qualify for a hardship distribution. Most of the time, the IRS charges income tax plus an extra penalty on hardship distributions. However, there are a few situations that avoid the penalty.
The IRS defines a hardship distribution as one for an immediate and heavy financial need. The list includes the cost of buying a home, medical bills, funeral expenses and college tuition as expenses that would qualify for a hardship distribution. However, just because you pass the IRS's hardship rules doesn't guarantee you'll get your money. Your employer also needs to approve your distribution. Some plans restrict hardship distributions to certain expenses or don't allow them at all.
If you are allowed to take out a hardship distribution, the entire withdrawal is taxed as income. Most of the time, you will also owe an extra 10 percent early withdrawal penalty on top of the taxes if you take the distribution before you turn 59 1/2. You will also be frozen out of your 401(k) plan for the next six months. During this time, won't be able to add money back in your account or receive matching contributions from your employer.
There are a few situations where you can avoid the 10 percent withdrawal penalty. If you become permanently disabled and need to stop working, the IRS waives the penalty. You can also use your 401(k) savings to pay excess medical bills. If your bills for the year cost more than 7.5 percent of your income, you can make a penalty-free withdrawal to pay any bills over the 7.5 percent limit. Lastly, you can use your 401(k) funds to meet a court-ordered divorce settlement. In all these exceptions, you will still owe income tax on the withdrawal, but you avoid the penalty.
One other way to avoid the penalty is by taking out your 401(k) funds through a plan loan. Not all plans offer loans; it depends on your employer. If your plan offers loans, you can borrow up to half of your account up to a maximum of $50,000. You will need to pay this loan back into your account with interest within five years. Otherwise, the loan will count as a withdrawal and you'll need to pay income tax plus the penalty on whatever you haven't paid back.
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