Monday, May 22, 2017


Over the years I have seen many clients who have, without first consulting me, taken money from their 401(k) plans, while still employed, to assist in paying for excessive medical expenses, college tuition, or a downpayment on a home.

This is a very expensive way to get money.  A loan shark might be cheaper!

Money taken from a 401(k) plan will be fully taxed on a federal and state level and, if you are under age 59 ½ when you take the money, as has been the case in most of what I have seen among clients, you will also be subject to the 10% premature withdrawal penalty.

In most cases 40% or more of the amount taken from the account will be eaten up by federal and state taxes and penalties!  So if you take $10,000 from your 401(k) you will end up in pocket with less than $6,000.

It is similar with premature withdrawals from a traditional IRA, but with an IRA you might have a “basis” in your traditional IRA investment based on non-deductible contributions so the entire amount of the withdrawal may not be taxable.  With a ROTH IRA you can withdraw your contributions at any time without tax or penalty.

There are a limited number of exceptions that could allow you to avoid the 10% premature withdrawal penalty – but you would still need to pay federal and state income tax on the withdrawal.  Some exceptions apply to withdrawals from both 401(k) plans and traditional IRA accounts, and some apply only to premature IRA distributions.

You can avoid the 10% penalty if you take money out of a 401(k) plan, or a traditional IRA, “to the extent unreimbursed medical expenses exceed 10% (or 7½% if the lower threshold is reinstated) of AGI”.  So you can avoid the penalty on the amount of medical expenses that would be deductible on Schedule A.

If you take $10,000 from your 401(k) to pay for an excessive medical bill not fully covered by insurance (this would NOT include elective cosmetic surgery) and when you sit down to prepare your tax return you determine that your total allowable medical expenses for the year are $20,000 and your AGI is $110,000, you can avoid the 10% penalty on $9,000 of the withdrawal ($20,000 – $11,000 = $9,000).  You would still pay $100 in premature withdrawal penalty.

But in most cases of client 401(k) distributions the money has been used either to pay for college or for a downpayment on a house.  Money taken directly from a 401(k) plan for these purposes will be subject to the full 10% penalty.

However money taken from an IRA account and used for either of these two purposes is exempt from the penalty.  In the case of a downpayment on a home, the exemption is limited to $10,000 withdrawn and only applies for “first-time” home purchases (no home ownership in prior two years). 

According to the IRS, expenses that qualify under the college exception include –

. . . tuition, fees, books, supplies, and equipment required for enrollment or attendance at an eligible educational institution. They also include expenses for special needs services incurred by or for special needs students in connection with their enrollment or attendance.  In addition, if the student is at least a half-time student, room and board are qualified education expenses.”

The amount of expenses allowed must be reduced by any tax-free educational assistance.

So if you want to invade your 401(k) plan for college expenses or a home downpayment first check with the plan to see if you can have the amount of the withdrawal transferred (rolled over) trustee to trustee from the employer plan directly to your traditional IRA account.  Or take the distribution from the 401(k) and immediately rollover the amount yourself into the IRA account.  When that has been done take the amount of the transfer as a distribution from the IRA account and use the IRA money to make the college or home purchase payments. 

Instead of taking an actual withdrawal from your 401(k) you may be able to take a loan from the account.  Taking a loan from a 401(k) plan is not a taxable event.  However be aware that you must pay the money back to the plan, perhaps with some interest, before you leave the company.  If your employment is terminated you must pay back any outstanding 401(k) plan loan balance within a short period of time or the unpaid balance will be treated as a distribution, subject to income tax and penalty at that time.

The best advice I can give you is do not take the money from your 401(k) plan, or second best that if you are thinking about taking money from your 401(k) plan to pay for anything talk to your tax professional first!  If my clients had come to me they would have saved a lot of money.


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